Exchange Traded Funds (“ETFs”) are innovative investment vehicles that combine the trading flexibility of individual stocks with the diversification benefits of mutual funds. Like mutual funds, ETFs are pooled investments that represent ownership in a basket of securities, thereby providing more diversification than individual stocks. Similar to individual stocks, ETFs trade on an exchange and can be bought or sold throughout the day. This flexibility has made ETFs popular with a diverse group of investors and one of the fastest growing investment products today.
These investments may be especially appealing to investors who:
- Want access to specific market segments
- Seek trading flexibility similar to stocks
- Have a sizable amount to invest as a lump-sum
- Want to implement a buy and hold investment strategy
- Are interested in reducing management fees
- Understand the impact of trading costs
The trading of ETFs is identical to that of any listed stock, and allows investors to utilize market, limit and stop orders. ETFs can also be sold short or purchased on margin.
Advantages of ETFs
Low Expense: Unlike active mutual funds where the objective is to beat a respective index, ETFs are managed passively with the objective of matching the performance of their underlying index. Consequently, ETFs are generally able to operate with lower annual operating expenses than their actively managed mutual fund counterparts. Please note that commissions are charged on every trade.
Tax Efficiency: The unique structure of ETFs minimizes potential capital gains. Unlike traditional mutual funds, ETFs trade on an exchange insulating investors from taxable events generated by other investors. Since ETFs do not have to sell securities to cover investor redemptions, this increases tax efficiency while reducing potential capital gains.
Diversification: ETFs offer investors the opportunity to invest in a favorite sector yet avoiding the potentially negative effects a downturn in the market could have on a few individual stocks. ETFs can provide instant, diversified exposure by simply purchasing one security.
Trading Flexibility: ETFs trade throughout the day with continuous pricing. Therefore, you can place the same type of orders as for individual stocks. Shares can be purchased in odd lots as well as round lots, requiring a relatively low outlay of cash. ETFs are subject to risks similar to those of stocks, including those regarding short selling and margin account maintenance.
Transparency: The transparency of ETFs can help reduce duplication and help facilitate better tax loss strategies in your portfolio at year end. Since ETFs track a specific index, you have an exact understanding of the underlying securities.
Risks: ETFs are subject to risks similar to those of their underlying securities, including, but not limited to, market, sector, or industry risks, and those regarding short selling and margin account maintenance.