Today, we are going to talk about an often underused investing tool: exchange-traded funds, otherwise known as ETFs.
ETFs provide investors with the ease and safety of diversification while still allowing for all the ordinary features of equities.
Put simply, an ETF is a security that tracks a basket of assets, a commodity, or an index — similar to a mutual fund. But it can be bought and sold throughout the day on an exchange just like a stock.
Overall, ETFs are cost-efficient and tax friendly.
So, it should be no surprise that they have managed to gain mainstream popularity. In fact, analysts expect that ETFs will soon be more popular than mutual funds.
In a second, we are going to explore ETFs in detail and talk about some red flags of ETF investing.
But first, we wanted to take a second to explore the history of ETFs. This way, investors will have a good understanding of them before adding them to their portfolios.
The first ETF was traded in the U.S. in 1993, making ETFs a relatively new form of investment.
In fact, ETFs didn't even reach Europe until 1999.
But since that first U.S. trade, the number has grown to over 4,779 ETFs worldwide. That number has been growing at an accelerated rate over the last few years, with ETFs all but eating the market.
ETFs exist in dozens of categories, ranging from natural resources to small companies and government bonds.
And though they track the movements of the assets or indexes that they follow, the prices are not determined by the net asset values (NAVs) at the end of the day as with mutual funds. Instead, the values of shares in ETFs can go far beyond their underlying values as investors bid up the shares.
That said, investors must remember that the values also have 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 that mutual funds don't. Here are some of those benefits:
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. This tends to keep the ETF investor safe against unexpected capital gains at the end of a quarter.
Lower Fees. ETFs are no-load funds. This means that 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. This allows ETF investors to close their positions much faster than in mutual funds, which must be liquidated at the end of the day.
No Minimum Investment. Diversification can be tough for a new investor, especially if you're using a mutual fund. This is because traditional mutual funds frequently have minimum investments of $2,500 or more. ETFs, on the other hand, carry no minimums, which makes for easier asset allocations.
The key to successful ETF investments isn't as easy as just merely loading them onto your trays. Like stocks, the good ETFs swim alongside 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're 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 percentages. 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 this doesn't mean that they aren't 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 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.” This has become a bigger problem as ETFs become more popular. This means that these funds have greater risks associated with them since they lag the trends themselves. Moreover, because these new funds are largely untested, they have no track records to base solid buys on.
Longs: Avoid the Urge to Trade. In general, ETFs are like mutual funds. Meaning they are, in essence, long-term bets on broader market trends. So, avoid the urges 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 ETFs, you can begin to make a decision on whether they're right for you.
But before you go, we wanted to share a few red flags for you to look out for when shopping around for ETFs. Ignoring these red flags can be costly mistakes for any investor — regardless of their experience level.
I mentioned in the history section of this report that ETFs have skyrocketed in popularity.
This popularity has brought many new ETF providers charging into the space. And some of those providers are less established than others.
This means that when you are looking at an ETF to add to your portfolio, you need to take this major red flag into consideration...
A Lack of Transparency. Do you feel like you know what's going on within the ETF? If not, it may be time to stay away. If you're looking at an ETF on a website, and that website is unclear about the benefits or stocks in the portfolio, investors should be wary. After all, for investors to truly benefit, they need to make sure that the overall quality of the ETFs is sound. Use the points we made above to determine whether an ETF is a quality buy.
With that red flag in mind, you're free to move forward into the world of ETF investing.
Just remember to make smart decisions and analyze an ETF before you commit to adding it to your portfolio. You don't want to end up playing with a handful of useless cards.