There’s more to building your portfolio than buying stocks, bonds and mutual funds. Have you considered exchange-traded funds (ETFs)?
Exchanged Traded Funds, or ETFs, can be used as the building blocks of your portfolio or as a complement to other investments you own, providing further diversification. It all depends on your individual goals and circumstances.
An ETF is or exchange-traded fund is an investment fund through which investors can pool their money or invest in a preselected basket of securities that are traded as a package or stock exchange – which is how it gets its name. It has specific characteristics.
- ETFs offer investors a way to combine their money and invest as a group in a basket of securities.
- ETF shares are bought and sold throughout the day on an organized market, such as the New York Stock Exchange.
- ETFs are easy to track because investors can look up their trading price by checking their tickers.
If you are new to investing, it may still be a bit confusing as to what exactly an ETF is. Don’t worry, you’re not alone. Sometimes it helps to just break it all down.
And if you are already an experienced investor, you may want to skip ahead to “How does an ETF work?”
An ETF is an exchange-traded investment fund through which investors can pool their money to invest in a preselected basket of securities, which are tradeable financial assets, such as stocks, bonds, currencies, futures contracts and/or commodities, or some combination of these investments. An ETF can own thousands of securities.
You are investing in a basket (group) of securities that are tradeable financial assets. As mentioned above, an ETF is an exchange-traded investment fund through which investors can pool their money to invest in a preselected basket of securities, which are tradeable financial assets, such as stocks (shares of a company), bonds (loans to a company or government), currencies (various forms of money, including foreign currency), futures contracts (legal agreements to buy or sell something in the future) and/or commodities (such as crops or natural gas), or some combination of these investments.
Thus, when you invest in an ETF, you and your fellow investors pool your money and invest in multiple securities simultaneously. Each share you purchase gives you a little piece of every security (asset) included in the ETF.
The process all starts with an ETF sponsor, usually a fund manager, who creates an investment management strategy based on studying various securities and their performance. The plan is submitted to the Securities and Exchange Commission (SEC) for approval.
Once the plan is approved, the securities that align with the strategy for the newly approved ETF are obtained and placed in a trust. Then, creation units (large blocks of shares – typically 50,000 or more) are formed, based on the value of the ETF. The creation units, which represent the value of the securities in the ETF, are divided into shares. These shares are then sold to investors on an exchange.
After an ETF’s shares have been created, you can buy and sell them via a brokerage firm/broker (including online brokers and robo-advisors) throughout the day on the ETF’s chosen stock exchange. Thus, the ETF’s share price can fluctuate from hour to hour. Because ETFs can create shares when they are needed or redeem them when they are not, the number of available shares each day can vary, as well. In addition to your initial investment, you will typically pay an administrative fee for administrative costs, possible brokerage commissions (depending on your broker) and transaction fees (required by the SEC) for the sale of ETF shares. In return, as an investor, you will get a share of the fund (based on what you purchase), possibly entitling you to dividend payments, capital gains distributions or other benefits. You can learn details about how your specific ETF works by reviewing its respective prospectus, which you can request from your financial advisor.
There are many types of ETFs, each varying in terms of asset type, tax implication, and expense ratio. The most common ETF categories include:
Equity ETFs invest in various stock assets, usually tracking stocks in a particular industry or in an entire index of equities such as the Dow Jones Industrial Average (DJIA) or the S&P 500 Index. Equity ETFs may own stocks, generally selected based on company location, sector, or size.
Fixed-Income ETFs (bond ETFs)
Fixed-income ETFs (bond ETFs) invest in bonds, which are fixed-income securities. Most Bond ETFs focus on a specific subset of bonds, such as government bonds or corporate bonds, and are generally lower risk, which helps to reduce your portfolio’s volatility. Bond ETFs trade throughout the day on a centralized exchange, as opposed to individual bonds, which are sold by bond brokers.
Commodity ETFs invest in physical commodities such as natural resources or precious metals. Commodity ETFs give you either ownership in the fund’s physical stockpile of a commodity or give you equity in companies that produce a commodity or commodities.
Currency ETFs track a single currency or a basket of currencies and are often backed by bank deposits in a foreign currency. Having investments in non-dollar currency can provide your portfolio with even more diversification.
Broad stock ETFs
Broad stock ETFs are diversified, often giving you exposure to multiple sectors (energy or real estate, for example), individual securities and — in the case of international ETFs — several countries. Broad Stock ETFs generally don’t rely too heavily on the performance of a certain type of company or a specific country.
Broad bond ETFs
Broad bond ETFs invest in different areas of the fixed-income market, such as corporate and government securities, which generally makes their returns less dependent on the performance of specific sectors. Examples of Broad ETFs include government and corporate ETFs.
ETFs offer benefits such as low costs and diversification, which can make them attractive investments. But you should consider your goals, risk tolerance and the types of investments you prefer to own when determining whether ETFs are appropriate for you.
The benefits of investing in ETFs may include:
- Low costs: Most ETFs track broad market indexes, so they don’t have to pay portfolio managers to analyze and trade shares for the fund. This generally makes owning an ETF less costly than owning an actively managed mutual fund.
- Diversification: Instead of holding just one investment in an individual company, ETFs invest in a diversified portfolio of individual stocks or bonds, and you buy shares in that fund, which helps even out the ups and downs in the market.
- Fewer broker commissions: Because ETFs invest in a diversified portfolio including multiple securities, usually only one trade is needed compared to individual stocks or bonds.
- Tax efficiency: Because ETFs often mirror index mutual funds, they generally trade less often and generate fewer transactions that are taxable, which means fewer expenses for investors.
ETFs also have disadvantages, which are important to understand and consider.
- Lack of control: Investors cannot directly control or influence which securities are included in the fund’s portfolios.
- Extra costs: ETF shares trade on stock exchanges; so, every time an ETF share is bought or sold, the fund may incur a broker’s commission. ETFs also have bid-ask spreads, in which shares are purchased at the ask price and sold at the bid price, with the spread between the prices adding to the ETF’s transaction costs. The wider the bid-ask spread, the higher the cost to trade.
- Overtrading: The potential ease of trading in and out of ETFs may tempt some investors to overtrade instead of following a more appropriate long-term investment strategy.
- Liquidity: Some ETFs may be more difficult to sell, making them less liquid than you’d like – especially if you need the money quickly.
Track record: Assess an ETF’s track record to evaluate whether it has met its performance objective. In general, you should review at least one year of actual performance history, as most ETFs should perform similarly to the underlying benchmark index. You should also review how the benchmark index itself has changed over time, as this can cause the ETF to perform differently.
Low expenses: Many ETFs have lower expenses because they’re passively managed. Passively managed ETFs representing a certain asset class tend to be similar, so costs can be an important difference. The following represents a general guideline for ETF expenses:
The expense ratio measures what percentage of a fund’s assets are used to pay for the operating and administrative expenses of that fund, which reduce an investor’s return. The expense ratio of a particular ETF may be higher or lower than the guidelines noted in the chart above. You should carefully review the prospectus for the ETFs expense ratio.
More than $100 million in assets under management (AUM): Hundreds of ETFs have been launched in the past few years, and many still have marginal assets under management. Edward Jones suggests 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 NAV of the fund’s underlying holdings primarily determines an ETF's price, along with the supply of and demand for shares in the market. This may cause an ETF to trade at a premium or discount to its NAV. Edward Jones suggests seeking 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. The premium or discount could also be more significant for more narrowly focused ETFs.
- Tax implications: An ETF’s holdings may affect capital gains or dividend distribution taxes. While most ETFs are legally structured as open-ended funds, meaning there is no limit to the number of shares the fund can offer, some may not be. Certain ETFs may generate a K-1 tax form, which may be undesirable for some investors. You can find the details on fund structure and tax implications in an ETF’s prospectus. Talk to your qualified tax professional about your situation.
- Underlying holdings: Understanding an ETF’s underlying holdings can help identify significant weightings to individual securities, industries, sectors or geographic locations, which may indicate the ETF is not as diverse as it seems. Knowing how the ETF is invested can lead to fewer performance surprises.
- How to invest in ETF funds: Like stocks, ETFs trade on an exchange. This means you can place different types of orders, and the time of day you place an order can affect the price you receive. ETF prices may be more volatile near the market’s opening and closing. Talk with your financial advisor to understand order types and their implications.
Broad-based ETFs can make up the core building blocks of your portfolio. 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’s an ETF for you.
You can also incorporate ETFs representing various investment styles — for example, dividend income or capital appreciation — into your portfolio.
ETFs can provide lower-cost, broad exposure to asset classes that can help further diversify your portfolio. Do you already own several individual large-cap domestic stocks? You may wish to speak to your financial advisor about how an international or small-cap ETF may fit into your portfolio. Similarly, if you own many individual bonds, consider speaking to your financial advisor about how a broad intermediate or short-term fixed income ETF may benefit your portfolio.
You can use ETFs with mutual funds to achieve even more diversification.
For example, an ETF could fill a gap in your portfolio of mutual funds. If you already own several large-cap domestic equity and international equity as well as fixed-income mutual funds, you may further diversify 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, you may 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. Remember, before you supplement your portfolio with other investment types, you should speak with your financial advisor and read the fund's prospectus documents as you may be eligible for break points — or lower fees — if you invest a certain amount with a specific mutual fund family.
How can I get started investing in ETF?
If you are a seasoned investor, have a brokerage account and have a financial plan, it’s easy to get started. After you’ve reviewed your options and narrowed down which ETF(s) you want to invest in, you can buy and sell ETF shares via a brokerage firm/broker (including online brokers and robo-advisors) throughout the day on the stock exchange. Tip: ETF prices may be more volatile near the market’s opening and closing. Consider talking with your financial advisor to understand order types and their implications.
If you are a seasoned investor, but don’t have a brokerage account, it’s also easy to open one. You can even do it online.
If you are at the beginning of your financial journey and are a bit of a self-starter, we have online resources to help you find your starting point and set your path to establish a financial strategy. If you want a little more help, you can get started by finding an Edward Jones financial advisor today, who can help you understand what questions to ask, how to decide which or if an ETF is right for you and how to build a solid long-term strategy and an investment portfolio.
Most people recognize that reaching their financial goals is a journey. At Edward Jones, you have a range of investment choices to work with and flexibility in how you manage them and how active you want to be. Please review this important information about our brokerage services (PDF).
ETFs are sold by prospectus. The prospectus contains the fund’s investment objectives, risks, charges and expenses, and other important details to consider. Your financial advisor can provide a prospectus, which you should read carefully before investing.
Diversification does not guarantee a profit or protect against loss.