|
| What is an ETF? |
| Exchange traded funds–or ETFs–are all the rage these days in the investment community. Not a day goes by without some mention in the mainstream press of their growing popularity. But what is an ETF? And should you be investing in one? |
|
| We'll start with the first question. An ETF is basically a basket of investments (stocks or bonds) that in most cases are designed to mirror the performance of a specific market index. For instance, there are ETFs that track the stock market as a whole through the S&P 500. You also can purchase ETFs that offer exposure to different investment styles (mid-cap value, small-cap growth, etc.), industry sectors, and commodities–such as gas, wheat, and gold. |
|
| Most ETFs are passively managed. That means there isn't a portfolio manager actively tweaking the fund's investment strategy in response to changing market conditions. This differentiates them from mutual funds. Structurally, mutual funds are similar to ETFs in that they combine a group of investments into a single portfolio which can be purchased as a single investment. However, mutual funds tend to be actively managed–a manager or team of experts is making strategic buying and selling decisions with the fund's underlying investments in an effort to improve performance. (This is not always the case, as there are index mutual funds that are passively managed. A passively managed fund is a fund whose investment securities are not chosen by a portfolio manager, but instead are automatically selected to match an index or part of the market.) |
|
| The structure of an ETF also allows it to be traded like a stock. As such, it can be traded throughout the day, and its price will fluctuate accordingly. In contrast, a mutual fund is structured to be bought or sold at a set price at the conclusion of the trading day. Because an ETF can be bought and sold like a stock, investors can employ some fairly sophisticated–and often very risky– investment strategies, such as buying a security with credit (buying on margin) or selling securities that have been borrowed from a third party with the intent of buying the same amount later at lower price and returning them (short selling). Many experienced investors saw this as an advantage during the recent downturn as the markets fluctuated wildly from day to day, and sometimes from hour to hour. This is why, in part, ETFs garner so much press. |
|
| Another benefit of ETFs is that they tend to be more tax efficient than mutual funds and bear lower fees and expenses. That's because with an actively managed mutual fund you are paying for a team of experts to oversee the fund in an effort to beat a performance benchmark (though not all managers are successful in that regard). |
|
| Short-Term Benefits |
| So, should you invest in an ETF? Well, it depends on what you are trying to do. If you are looking for an investment vehicle that gives you more control and flexibility, and can be traded daily, then ETFs make more sense than mutual funds. And because they have lower fees and expenses, ETFs are better suited for short-term, tactical investment strategies (though the benefit of lower fees can be quickly erased by brokerage commissions if you are trading frequently). But active trading is a very difficult strategy to pull off successfully. Most people don't do it well and end up losing money as they jump from one hot sector to the next, often buying high and selling low. |
|
| With a retirement account such as a 401(k), company retirement plan or an IRA, ETFs aren't as popular. Among the reasons is that tax efficiency is irrelevant in a tax-deferred account such as these. And, it generally isn't appropriate to actively trade investments in a retirement account. |
|
| If your retirement plan does offer ETFs as an investment choice, you should treat them no differently than you would a mutual fund or any other investment vehicle within your plan. Your primary objective should be to ensure that you are appropriately diversified across the asset classes (cash, stocks, bonds). |
|
|
|
> Home
> Glossary > Support |
