Why invest in Exchange Traded Funds(ETFs)?

Monica Singhania

Benefits of investing in ETFs

Diversification of Risk

  • Investors are constantly seeking opportunities to maximize their investment returns and minimize their risks. Allocating investments to different asset classes (equities, bonds, commodities, currencies and real estate) that are not perfectly correlated offers one such opportunity to optimize returns.
    • For instance, an investor seeking an allocation of 70% stocks and 30% bonds can easily create such a portfolio with ETFs.
    • That investor can further diversify by splitting the stock portion into US stocks and Emerging Markets stocks, and the bond portion into Corporate and Government bonds.
    • By regulation, a domestic ETF must hold at least 13 securities and cannot invest more than 30% of the fund in any one security or more than 65% in the 5 most-heavily weighted securities.
    • For international ETFs, the rule is a minimum of 20 securities and a limit of 25% in one and 60% in the top 5. Most ETFs hold many more securities and have a maximum concentration of 5 to 10% of the fund.
  • There are hundreds of ETFs available to choose from and they cover a wide variety of asset classes and sectors:
    • US / International Equities
      • Major Indices – Dow, S&P 500, Nasdaq etc.
      • Sectors – Energy, Bio-tech., Consumer Goods etc.
      • Other categorizations – Large caps, Small caps, Growth, Value
    • US / International Bonds
      • Government Bonds
      • Municipal Bonds
      • Corporate Bonds
    • Commodities
      • Metals (Precious/ Base metals)
      • Agro commodities
      • Energy
    • Currencies
      • Euros, Japanese Yen, Pound Sterling etc.
    • Real Estate
      • US Residential / Commercial
      • International

Low Expense Ratios

  • Most ETFs have extremely low expense ratios (operating costs as a percentage of net asset value) compared with actively managed mutual funds, and their expenses are usually lower than those of equivalent index mutual funds.
  • As ETFs are held in a brokerage account, the ETF manager does not incur investor account expenses that drive up fund management costs.
  • Of course, ongoing low operating costs should be weighed against the costs of trading ETFs, such as brokerage commissions and bid-ask spreads
  • On average ETFs have an expense ratio of 0.4% of assets and no ‘entry/exit loads’. Compare that to an annual expense ratio of 1.4% for mutual funds on average, many of which also come with additional ‘loads’.
  • Although a 1% per year difference may not sound like much, it adds up over time. See our post on the free tool from FINRA that will calculate the cost differences between different funds over time. In our example, we calculated a $50,000 – $65,000 savings over a 20-year period.

Tax Efficiency

  • Because index funds generally have low portfolio turnover, they have the potential to be more tax-efficient than actively managed funds. (However, funds that track indexes with high turnovers, such as certain small-cap indexes, may be less tax-efficient.)
  • ETFs are tax efficient because they operate differently than mutual funds. If you buy a mutual fund, you are trading with the fund manager. Share redemptions cause the manager to sell investments to raise cash and creates a tax liability for the remaining shareholders regardless of how long they have held the fund’s shares.
  • ETF managers don’t redeem shares for cash – they simply transfer a basket of securities to the redeeming party in a tax-free transaction. As a result, the remaining beneficial owners of the ETF aren’t handed an unexpected tax liability.
  • As an individual investor, you will typically buy and sell ETF shares on a secondary market rather than trade directly with the ETF sponsor. A taxable capital gains event will occur only when you sell the ETF (there are exceptions – review the ETFs prospectus with your tax advisor).

Transparency

  • Unlike mutual funds, which reveal their holdings quarterly, the holdings of most ETFs are readily available.
  • Typically, investors will always know what to expect from an ETF – roughly the return of the market or target index minus the incremental costs of operations and transactions within the ETF portfolio.
  • With ETFs, there’s little risk that a fund manager will drastically underperform the benchmark.

Liquidity

  • ETFs can be traded throughout the day, unlike open-end mutual funds.
  • You can also place stop and limit orders, short-sell ETFs, or trade them on margin.

Achieving ‘Tilt’ in Portfolio

  • ETFs have opened up investment opportunities for the individual investor that were previously limited to the realm of hedge fund managers and institutions.
  • ETFs can now serve both ‘core’ and ‘satellite’ purposes in individual investor portfolios – where broader-based ETFs with lower historical volatility form the core and more targeted/ leveraged ETFs with specific / niche sector exposures add some ‘spice’ to the portfolio.
  • Using ETFs, individual investors can also take negative positions in asset classes. Such positions (e.g. short USD, long JPY) can serve the purpose of either trading on a pinpointed negative view of the asset class or hedging out a market risk associated with the portfolio.
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Monica Singhania

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