The investment world has a variety of options people can invest their money in. Mutual funds are the most common investment vehicle used but Exchange Traded Funds (ETFs) are climbing the ladder.
What are Exchange Traded Funds (ETFs)?
The United States, in 1993, launched a class of Index Funds that trade just like common stocks; meaning, they trade throughout the day on the stock exchange. These Index Funds are known as Exchange Traded Funds or ETFs, and they correspond to their underlying index (hold same component of stocks and their weighting) while staying fully invested. Selecting the right stocks to invest in can be a challenge, so when there are bull markets calling for a correction, or there are geopolitical concerns or an increasing interest rate environment to consider, the challenge is even harder. Broad diversification will become more crucial for investors who need to adapt to this shifting landscape, and Exchange Traded Funds may be the solution.
- Transparency – Being transparent allows you the investor, to see exactly what you own
in each fund. This provides less overlapping of the same stock in each fund you own, unless of course you choose to overlap.
- Fees – Low cost fees mean your return is not reduced by high expenses.
- Liquid – Intraday trading provides liquidity at the current price as ETFs are traded throughout the day. Mutual funds are only traded and valued at the end of day.
- Diversified – Diversification occurs through just owning an Index ETF of your choice; This is because an index fund follows the entire specific market and is diversified within the index.
- Tax Efficient – You manage your own taxes by selling shares only when you want to sell, making this a beautiful part of owning ETFs.
Drilling down a little more regarding this tax benefit: mutual fund managers are buying and selling all year long, yet you do not see these transactions until the year ends and mutual fund companies disclose the tax implications you will have to pay. You may have held the mutual fund all year long and have not sold or purchased any other shares (except for automatic dividend reinvestment). Then at the end of the calendar year you may have a long term or short term capital gain tax liability. ETFs incur a tax liability only if you choose to sell your own shares; there are no hidden capital gains/losses.
Exchange Traded Funds also offer a variety of options to invest in, and they keep growing. State Street Advisors launched the Standard and Poor Depository Receipt (SPDR® ETFs, known as Sector SPDR® years ago and these are most popular for individual sector investing. These ETFs follow the S&P 500 Index by allowing you to invest in the nine different sectors that make up the S&P 500 Large Cap Index. I like the SPDRs® because if I want to only invest in energy companies and not healthcare companies, I can buy the Energy Select Sector SPDR® Fund, (XLE) and own only the energy companies in the S&P 500 Index. A portfolio can also be structured to hold all of the nine Sector Spider ETFs with any dollar amount in each sector. My portfolio then becomes personalized to my investment standards and not part of a model.
iShares® is another familiar name for ETFs. IShares® is a family of ETFs managed by BlackRock Fund Advisors. The most well known iShares® is the Core S&P 500 ETF, (IVV). This provides exposure to large, established companies in the U.S. The mid-cap and small-cap also represent established companies in the U.S. through the iShares® Core S&P 600 Small-Cap ETF (IJR) and S&P 400 Mid-Cap ETF (IJH).
International markets are not left out of the ETF arena. You can invest in broad scope international markets or specifically in individual countries.
The list of iShares® is very long. Some examples of individual country ETFs are Germany (EWG), Japan (EWJ) and Mexico (EWW). Individual country ETFs may have currency risk exposure, so this needs to be considered when investing outside of the U.S. View the full (Oct. 2014) list here
One well known fund family, Vanguard, also provides many ETFs. And on June 17th of this year, another well known company, JP Morgan, announced its entrance into this investment option with their first ETF, a Diversified Global Equity ETF, (JPGE). As I have indicated, there are several investment options for you to invest your money in; choosing the right one for your investment strategy is the challenge.
I have been describing the characteristics of equity ETFs, but the list of options is even longer: Another asset class of ETFs to look at is fixed income, also known as bonds. Similar to equities, fixed income ETFs have a wide array to select from. You can build your own diversified bond portfolio by using the different ETFs for specific sectors: corporate bonds, municipal bonds or international bonds, to list a few. Or you can own a broad market exposed bond fund that holds investment grade bonds with the common ETF, known as the U.S. Aggregate Bond Fund, (AGG). It is important to remember that bond funds are subject to interest rate risk, and this will impact the price movement. Due to this risk, bonds are not as conservative as some may believe, however, they should play a role in your diversified portfolio.
Utilizing ETFs in a 401(k) Plan
The 401(k) industry is a good place for ETFs because of the low cost fees. Your 401(k) retirement plan needs to earn the most it can, but when some mutual funds are used, the high expense fees really take away from your retirement value. Check out Bryan Sanford’s article, “Indexing, Solution to 401(k) Investment Strategy” in the latest spring issue. An ETF index strategy can work nicely in this scenario. I believe a shift towards holding ETFs in 401(k) plans will be commonplace in the near future. Making participants aware of these low cost vehicles is the challenge.
I hope this helps you to better understand Exchange Traded Funds and the importance they can play into a portfolio. A diversified portfolio can hold some individual stocks and individual bonds along with a few ETFs to complement.
Good luck and know what you are invested in.