By Elliot M. Kass | American Express Credit Intel Freelance Contributor
5 Min Read | November 1, 2021 in Money
ETFs can help ordinary investors diversify their investment portfolios.
The costs and taxes associated with ETFs are generally quite low and the funds are typically easy to buy and sell.
Most ETFs offer modest returns, but some riskier and more expensive ETFs can provide more profit potential.
People who don’t want to put all their financial eggs in one basket can consider investing in ETFs.
Short for exchange-traded funds, these investments target particular financial markets, like U.S. treasury bonds or the stock shares of high-tech companies, by purchasing a broad array of securities within that market segment. This gives people who buy shares in the ETF a simple way to diversify their holdings (the contents of their investment portfolio). Because an ETF pools funds from many thousands of investors, it can afford to purchase a variety of assets within its category – far more than most individual investors ever could.
Many ETFs also specialize in smaller subsets of larger markets, like utility stocks or municipal bonds, giving buyers more ways to broaden their market exposure.
ETFs trade like stocks and are listed on exchanges like the New York Stock Exchange (NYSE) and NASDAQ. They are bought and sold through brokers at market prices that may be somewhat higher or lower than the net asset value (NAV) of all the cash and securities held by the ETF. This is similar to shares of stock that may sell above or below the company’s “book value,” or the total amount a company would be worth if it paid all its debts and sold all its assets.
Because they can be traded so easily and due to the diversification they can provide, ETFs have become very popular in recent years. There are over 7,000 different ETFs worldwide,1 more than 2,000 of which are based in the U.S.2 The latter have over $4 trillion in assets under management.3
Most ETFs are passively managed investments, so the securities in them aren’t traded often. Instead, they’re generally bought and held for long periods of time. Passive investments typically seek to match the performance of a particular market index, like the Dow Jones Industrial Average.
Since these funds tend to require less attention from the fund’s manager, management fees may amount to less than 0.05% of the shareholder’s investment per year – and sometimes there are no fees at all. Less trading also means lower taxes, since a fund only pays taxes when it sells some of its holdings and realizes a gain.
Some ETFs, however, are actively managed, meaning that a portfolio manager (often supported by a team of analysts) actively trades securities to take advantage of price fluctuations and hopefully outperform the market index on which the fund is based. This is commonly known as “beating the market.”
When successful, actively managed ETFs can generate greater returns than their passively managed counterparts; but when they fall short, their losses also tend to be greater. And win or lose, they charge their shareholders higher fees – 0.66% on average in 2019 – and their more frequent trading leads to higher taxes.4
Like any type of investment, there’s an upside and a downside to investing in ETFs. Here are some of the biggest pros:
On the other hand, ETFs also have certain disadvantages, including:
ETFs are investments that can help investors diversify their holdings. These popular funds trade like stocks and allow even the smallest of investors to participate in a broad range of market segments at a low cost. Their returns, however, are generally modest and investors who buy into them must surrender a degree of control.