Exchange-traded funds, or ETFs, provide investors with the ease and safety of diversification while still allowing for all of the ordinary features of an equity.
An ETF, put simply, is a security that tracks a basket of assets, a commodity, or an index — similar to a mutual fund, but which can be bought and sold throughout the day on an exchange, similar to a stock.
The first ETF traded in the United States in 1993, making it a relatively new form of investment.
In fact, ETFs didn't even reach Europe until 1999. But since that first trade, the number has grown to over 1,438 ETFs worldwide, with categories ranging from natural resources to small companies to government bonds.
And though they track the movement of the assets or indexes they follow, the price is not determined by the Net Asset Value (NAV) at the end of the day as with a mutual fund. Instead, the value of a share in an ETF can go far beyond its underlying value as investors bid up the shares.
That said, investors must remember the value also has the potential to move in the other direction, and therefore must be watched closely.
Although ETFs are susceptible to market movements like stocks, they offer a number of benefits mutual funds don't. Here are some of these:
Tax Efficiency – Unlike a mutual fund that must pass along its capital gains to its shareholders, an ETF is usually taxed only when the shares themselves are sold. That tends to keep the ETF investor safe against unexpected capital gains at the end of a quarter.
Lower Fees – ETFs are no-load funds. That means you won't be slapped with a redemption fee when you decide to close your position. Moreover, ETFs typically have lower annual fees than traditional mutual funds.
Liquidity – The exchange-traded structure of an ETF gives it much greater liquidity in the markets. That allows ETF investors to close their positions much faster than in a mutual fund, which must be liquidated at the end of the day.
No Minimum Investment – Diversification can be tough for new investors, especially if you're using a mutual fund. That's because traditional mutual funds frequently have a minimum investment of $2,500 or more. ETFs, on the other hand, carry no minimums, making for easier asset allocation.
4 Rules for Successful ETF Investments
The key to successful ETF investments isn't as easy as just merely loading them up onto your tray. Like stocks, the good ETFs swim along with the bad.
A little common sense, however, goes a long way...
Here's what you need to consider before placing your bet:
Know what you are buying. The important thing to understand is exactly what your ETF is supposed to track. Moreover, if your ETF holds many different assets, it's important to know the breakdown of each of them by percentage. Taken together, that information will give you a better idea of how your fund may perform — especially in a down market.
Don't chase price, chase performance. ETFs may be diversified, but that doesn't mean they are not susceptible to momentum price swings. Remember that they trade like stocks and can become wildly overvalued in the short run. So use each fund's Net Asset Value (NAV) as a guide to what the fund should cost.
Avoid the newer funds. ETF providers tend to develop new funds in the “hottest markets.” That means these funds have greater risks associated with them since they lag the trend itself. Moreover, because these new funds are largely untested, they have no track record to base a solid buy on.
Longs: Avoid the urge to trade. In general, ETFs are like mutual funds. That means they are, in essence, long-term bets on broader market trends. So avoid the urge to trade them. As long as your original thesis is correct, holding them only makes sense.
Now that you're more familiar with the ups and downs of exchange-traded funds, you can begin to make a decision on whether they're right for you.
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