As an investor, it’s best to control the amount of risk added to your investments. Rather than lay your savings on a roulette wheel (chance of winning 2.63%, payout 35:1), you can mitigate risk in your portfolio. One way to do that is through exchange-traded funds (ETFs).
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- How Do ETFs Work?
- Pros of ETFs
- Cons of ETFs
- See All 7 Items
How Do ETFs Work?
Overall risk can be reduced through investment diversification among asset classes, corporate capitalizations and industry sectors. Most individual investors cannot afford to own a portfolio of individual securities to achieve adequate diversification. A $4.95 stock commission on a $1,000 trade is only 0.495%, but on $100, it’s 4.95%. If you don’t have tons of money lying around, it is best to use funds to control costs.
A mutual fund gathers, collects and pools investor assets. With the power of large capitalization, the investment fund can buy diversification. A Standard and Poor’s 500 Index Fund like the Vanguard 500 Index (VFINX) allows you to own a portion of every company in the index, even if you only have $1,000. The SPDR S&P 500 (SPY) is an ETF that holds the same 500 stocks as VFINX, but whose shares trade like a stock on the New York Stock Exchange (NYSE). Most ETFs are indexed portfolios; they are created to track the return of a market index like the Standard and Poor’s 500. Some stock ETFs have active managers who adjust the contents of an ETF’s portfolio.
Pros of ETFs
Liquidity: ETFs are highly liquid, allowing investors to buy and sell a portfolio of shares of common stock with ease and transparency.
Immediate pricing: Investors know the price they paid for an ETF immediately upon purchase, and they can also sell the portfolio on the same day and instantly know the proceeds of the sale.
Known quantities: ETFs are known quantities with predetermined portfolios, and they are not subject to changes made by an active manager.
Consistent weightings: The net asset value of an ETF is based on the same weightings of the same shares every day, providing stability and predictability.
Cons of ETFs
Market-driven prices: ETF share prices can be influenced by the forces driving the overall stock market, causing their market price to deviate from the net asset value of the fund.
Potential for discount or premium: Unlike open-end funds, ETF shares may trade at a discount or premium to the value of the underlying investments they hold, leading to potential disparities between market price and net asset value.
Liquidity concerns: Smaller ETFs may face liquidity challenges, especially during market downturns, which can result in trading at a deep discount to its net asset value.
Risk of selling crisis: Illiquid ETFs may experience a selling crisis, leading their shares to trade at a significant discount to their net asset value.
Examples of ETFs
SPY was the first ETF listed in the United States and was designed to correspond generally to the price and yield performance of the S&P 500 Index. It is the largest ETF of its type at over $250 billion in assets under management.
As with all investments, a greater risk may equal a greater return. An ETF like SPY spreads risk among 500 companies. The Invesco QQQ Trust (QQQ) spreads risk among fewer companies — the NASDAQ 100 — and thereby achieves the highest returns among large-capitalization ETFs. QQQ’s expense ratio is slightly higher than other indexed ETFs, but its concentration of assets into stocks of very few companies may be more worrisome.
QQQ holds over 30% of its assets in the stocks of Microsoft, Amazon and Apple. Rather than a narrower slice of the market, Vanguard Total Stock Market (VTI) takes a broader look at the market by tracking the CRSP U.S. Total Market Index of over 3,600 companies of all sizes and industries. Even with that much more expansive scope, VTI has kept pace with the narrower indexes, stayed positive for 2018 and maintained a minuscule expense ratio.
Where to Buy ETFs
ETFs are available from any bank or broker that sells securities, but that does not mean that ETFs should be purchased anywhere. Commissions vary widely in the brokerage business, as does the quality of service.
Carefully select the firm you use for ETF transactions. Technical support for a securities brokerage account is like financial property and casualty insurance. When it comes time to sell, a little extra expense can mean savings through efficient trading. Also, many brokerages offer commission-free ETFs, like Ally, E*TRADE, and TD Ameritrade, to name a few.
Investor Control
ETFs are one step beyond mutual funds in risk and one step toward preferential control by you, the individual investor. Total return is not the only measure of performance for an investment portfolio. You must feel confident that assets are appropriately invested, and ETFs allow you to assert more influence over underlying portfolio contents without owning individual common stocks.
Want to learn more? Check out Benzinga's guides to free stock trading, the best online brokerages and the best S&P 500 ETFs.
Frequently Asked Questions
What was the first exchange-traded fund (ETF)?
The first ETF was the Toronto Index Participation Shares, launched in 1990.
How is an ETF different from an index fund?
An ETF is similar to an index fund but has key differences. ETFs can be traded throughout the day on an exchange, have lower expense ratios, are more tax-efficient and offer more flexibility in terms of investment strategies.
Should I buy an ETF?
When deciding whether or not to invest in an ETF, it is important to consider your financial goals, risk tolerance and investment strategy. ETFs offer diversification and low-cost access to specific markets or asset classes. However, it is crucial to research and understand the specific ETF, including its holdings, expenses and performance. Consulting an investment adviser is recommended before making investment decisions.