ETFs are an incredibly powerful tool that investors can use to diversify their portfolio with just a few simple clicks. What is an ETF? An ETF, also known as an exchange traded fund, is essentially a grouping of different stocks or bonds, bundled and sold together. This allows you to buy little pieces of a bunch of different companies for a rather low price, instead of buying individual shares or bonds (which can add up quickly).
That all sounds great, but what kinds of securities (stocks or bonds) are included in ETFs? Well, they typically include securities that are tracked by different indices. For instance, you can buy an ETF that tracks the S&P 500, the NASDAQ 100, or a smaller cap index like the Russell 2000. For an ETF that tracks the S&P 500 it would be composed of almost exactly all the same companies found on that index, however there will be some variance. This is where the term index fund came from, an index fund is an ETF. ETFs are not limited to only tracking indexes. When they are set up, they may also include a bunch of different companies in the same industry or have some other commonality. For instance other types of ETFs you may find are pharmaceutical ETFs, tech ETFs, socially responsible ETFs.
Just like mutual funds they are generally considered a diversified investment since they are composed of many securities. They also can lack diversification. For instance, if you buy an ETF that tracks the health industry, then obviously you only have money invested in that one industry which is riskier then being spread out over multiple industries. Depending on your investment goals it is usually a better idea to use a range of ETFs in a portfolio to reduce your risk.
ETFs are not actively managed, they are considered passive, there is no portfolio manager adjusting things. Once the ETF has been established to track an index or industry that’s it, no more work goes into it. Unlike mutual funds, where a portfolio manager is trying to beat the market by spending their workdays analyzing and changing the investments in the lineup. This is a major difference between mutual funds and ETFs. Both however, will usually be presented in a company’s retirement account (401k, 403b).
ETFs do carry an expense ratio like mutual funds. Since they are not actively managed like mutual funds, you guessed it, they are usually cheaper. The expense ratios are much lower on average than mutual funds because once the ETF has been set up, there really isn’t any more adjusting to the underlying securities. An average ETF expense ratio is right around 0.44%, you may find some as low .02%. This is why they have gained popularity in recent years!
ETFs are generally a good investment vehicle if you have some understanding of the market, and know where you want to put your money, but don’t want to spend time buying individual stocks, and looking at company financial reports. Overall, they can be a great addition to investment portfolios whether you’re looking for dividend income, long term growth, high risk high reward bets, or just a safe place for your money, there is an ETF out there that will suit your needs!
You can continue your learning of ETFs by visiting one of our favorite resources, Investopedia: definition of an ETF.