Exchange-traded funds (ETFs) combine the flexibility of stocks and the portfolio-diversifying strengths of mutual funds, making them a viable building block for your investment portfolio.
What is an exchange-traded fund or ETF?
An ETF is a fund that holds a variety of securities in one investment category or class that are generally passively managed. ETFs trade on an exchange, just like stocks, and therefore experience price changes throughout the day. Most ETFs are managed in a rules-based manner that's designed to track the performance of a particular index, typically done by investing in the same securities as the index.
In the financial industry, most ETFs are "passively managed." A passive investment attempts to replicate the performance of an entire asset class, neither outperforming nor underperforming how an average dollar invested in that asset class would perform (net of fees).
Investments become more active as they attempt to do something other than track a particular asset class, usually to outperform the market, take less risk, and/or achieve some other outcome, such as producing more income. As you move further across the spectrum toward actively managed investments, more decisions are based on human judgment rather than rules. Mutual funds are actively managed.
ETF vs. index fund
An investment index is a way to observe a big cross-section of stocks or bonds. For example, the Standard & Poor's 500 (better known as the S&P 500) is one of the world's best-known indexes. It's the most commonly used benchmark for the overall stock market. But because, technically, you can't actually buy an index, an ETF is one way to invest in a broad market segment or the market as a whole. This is because ETFs trade on a stock exchange and experience price changes throughout the day as they're bought and sold. Some popular ETFs include SPY for the S&P 500 and AGG, an aggregate bond ETF.
ETFs and stocks and bonds
ETFs can be used as the building blocks of your portfolio or as a complement to other investments you already own, providing further diversification. If you're interested in investing in a specific asset class, such as large- or small-cap equity, international equity or fixed income, chances are there is an ETF available that covers it. By providing low-cost, broad exposure to asset classes, they can help diversify your portfolio.
For example, if you already own several individual large-cap domestic stocks, a broadly based international or small-cap ETF can help further diversify your portfolio. Similarly, if you don't own many individual bonds, you could benefit from a broad intermediate- or short-term fixed-income ETF.
ETFs and mutual funds
ETFs can also be used with mutual funds to achieve additional diversification. For example, an ETF could fill a gap in a portfolio of mutual funds. If you already own a number of large-cap domestic equity and international equity, as well as fixed-income mutual funds, you can increase diversification by adding exposure to the mid- or small-cap asset classes. If the mutual fund family doesn't have a fund that meets your needs, consider adding a mid- or small-cap ETF instead.
ETFs also can provide exposure to certain asset classes with a more limited number of fund choices, such as emerging markets or international small cap.
If you already have a well-diversified portfolio of mutual funds with different investment categories and asset classes, ETFs may not be necessary. Before you consider supplementing your portfolio with other investment types such as ETFs, see if you're eligible for breakpoints – or lower fees – if you invest a certain amount with a specific mutual fund family.
There is no universal figure for the amount of active or passive investments to include in a portfolio. Your considerations may include your desired level of involvement, sensitivity to fees, tax sensitivity and long-term expectations for the investments (e.g., outperform the market). If potentially lower expenses and greater tax efficiency appeal to you, a passively managed fund (especially an ETF), may be appropriate. If you prefer not to make individual investment decisions and want the chance to outperform the index, an actively managed fund may be appropriate.
ETF tax efficiency
Broad-based ETFs are relatively tax-efficient and low-cost compared to actively managed mutual funds, which can make them attractive long-term investments. It's important to consider that an ETF’s holdings may have an impact on capital gain or dividend distribution taxes. While most ETFs are legally structured as open-end funds, some may not be. Certain ETF structures may result in the generation of a K-1 tax form, which may be undesirable or confusing for some investors. The fund structure and tax implication details can be found in the ETF’s prospectus. Be sure to talk to your qualified tax professional about your situation.
Broad stock ETFs and your investment portfolio
Broad stock ETFs are diversified and can give you exposure to multiple financial sectors and individual securities and, in the case of international ETFs, a number of countries. This results in the ETFs’ performance being driven by several factors, rather than relying too much on the performance of a certain type of company or individual country.
Similarly, broad bond ETFs, like government and corporate ETFs, invest in different areas of the fixed-income market, such as corporate and government securities, which makes their returns less dependent on the performance of specific sectors of the market.
Our take on ETFs
At Edward Jones, we believe investors should focus on the traditional, more broadly diversified and passively managed ETFs because they're designed to provide you with exposure to multiple securities and sectors. And their performance isn't overly dependent on how well a certain type of company performs. Because so many ETFs are available, our financial advisors can help you narrow down your choices using the following criteria:
- Track record
One year of actual performance history is necessary to see how accurately an ETF tracks against its benchmark index. Your financial advisor can also help you review the benchmark itself to see how it has performed over time and whether that benchmark meets your needs.
- Low expenses
In general, because they're passively managed, ETFs tend to have low expenses. But we can help you compare ETF fees and give you the information to decide what's right for you.
- Underlying holdings
It's important to understand exactly what investments an ETF holds. Some ETFs have significant weightings to individual stocks, industries, sectors or geographic locations, and they may not be as diversified as you think. Making sure you are comfortable with how the ETF is invested can lead to fewer surprises.
- Assets under management (AUM)
Hundreds of ETFs have been launched over the past several years, and many are still quite small. We suggest investing in ETFs that have at least $100 million in AUM, which is the level we believe is helpful to sustain their operations.
- Share price premium or discount relative to net asset value (NAV)
The price of an ETF is determined primarily by the NAV of the fund’s underlying holdings in addition to the supply of and demand for shares in the market. This could cause an ETF to trade at a premium or discount to its NAV. Investors should seek funds trading at minimal premiums or discounts to NAV. Most broad-based ETFs trade within 2% of the fund’s NAV, although this spread could widen in periods of market volatility. Also, the premium or discount could be more significant for more narrowly focused ETFs.
Narrowly focused ETFs
In general, we don't recommend ETFs focusing on individual industries, countries or commodities. The more narrowly focused an ETF, the more dependent the fund’s performance will be on a certain kind of company or individual country.
Additionally, these funds can have large allocations to single companies. This can lead to higher volatility over time, with potentially more downside than an investor may expect. We believe most investors should focus on broad-based ETFs that offer diversification and can be held for the long term.
Leveraged and inverse ETFs
Leveraged ETFs seek to provide a return that's a multiple (such as two or three times) of the benchmark index’s return. Inverse ETFs seek to provide a return that is the opposite, or the inverse, of the benchmark index return. Returns for these ETFs can lead to unexpected performance results over longer periods. Therefore, we don't believe they're suitable long-term investments.
We can help
One of the reasons your financial advisor wants to get to know more about you and what you're trying to achieve is so we can provide the most appropriate investment recommendations for you. ETFs may be one of those ideas. Work with your local financial advisor to determine if ETFs may be right for you.
Exchange-traded funds are sold by prospectus. The prospectus contains more complete information, including the fund’s investment objectives, risks, and charges and expenses as well as other important information that should be considered. Your financial advisor can provide a prospectus, which should be read carefully before investing.
Diversification does not guarantee a profit or protect against loss.