The current bear market has many financial experts singing the praises of ETFs, but this investment vehicle has actually been around for more than a decade.
ETFs, or exchange traded funds, are investment vehicles that represent a grouping of stocks or bonds. They are traded throughout the day on major stock market exchanges. An ETF can hold thousands of companies or just a handful. Typically, the groupings are made according to an investing theme, such as the companies that make up the S&P 500 or biotech companies. Buying shares in an ETF is a quick way to diversify your investments without having to buy individual stocks. Because they are traded on the stock exchange, ETFs have ticker symbols. The symbol for the Diamonds Trust, which follows the Dow Jones Industrial Average, is DIA, for example.
ETFs v. Mutual Funds
ETFs and index mutual funds have a lot in common. Both track different segments of the market and represent a variety of trading companies. There are, however, key distinctions that make a world of difference.
With most mutual funds, investors pool their money to purchase stocks in the index tracked by the fund. When you invest in a mutual fund like the S&P 500, for example, the fund company uses your money to buy more stock in the S&P 500 companies when the market closes. An ETF, on the other hand, is a basket of stocks or bonds. When you buy or sell ETFs, your shares are coming from or going to another investor.
One key difference between ETFs and mutual funds is that ETFs can be traded throughout the day while mutual funds can only be traded when the trading day ends. This makes ETFs more liquid than mutual funds. In this volatile market, many financial advisors increased their clients’ ETF holdings as a way to maintain better control over their portfolios. ETFs also offer more transparency than many mutual funds, which only have to disclose their holdings four times a year. With ETFs, you always know exactly what is in the fund.
Should You Invest in ETFs?
Choosing between ETFs, mutual funds and other investment vehicle is a personal decision. ETFs offer some clear benefits, but there are some tradeoffs. For example, ETFs can rack up high transaction costs if you’re working with an expensive brokerage. Dollar-cost averaging, in which you buy in small increments, as opposed to a lump sum purchase, is not always wise.
Most advisors recommend ETFs most for long-term investors. ETFs are easily portable: If you want to move your holdings to another firm, you don’t have to liquidate and suffer a tax loss like you might with mutual fund holdings. ETFs also provide some tax efficiency advantages. With ETFs you pay taxes when you sell your shares on the capital gains. Mutual funds can be vulnerable to a wave of selling that would trigger undistributed capital gains in which you would be liable for taxes even if you didn’t sell any shares because you are the fund holder. The magnitude of this benefit is disputed, however.
Talk to your financial adviser about if and how ETFs can work in your investment portfolio. There is an array of ETFs to choose from that appeal to different levels of risk tolerance.
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