Here's Another Anchor For Diversification: ETFs

Looking for a way to ride out the ups and downs that may be inescapable for long-term investments? Diversification can be a safe harbor, and exchange-traded funds might be one of the ports that can anchor your portfolio.

An exchange-traded fund (ETF) is listed on an exchange and can be traded like stock, allowing investors to buy or sell shares in the collective performance of an entire stock or bond portfolio or an index as a single security. ETFs are subject to risks similar to those of stocks, including short-selling and margin account maintenance.

ETFs, which are similar in many ways to mutual funds, have been around for 25 years, and the number of ETF choices continues to grow each year. ETFs, like mutual funds, come in many flavors and varieties, so let’s lay out some of the basics.

Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by contacting the issuing fund directly, contains this and other important information about an investment company. TD Ameritrade clients can call 800-669-3900 to obtain a prospectus. Read carefully before investing.

Like a Mutual Fund, But Different

Like a mutual fund, an ETF is a diversified basket of securities designed to track a benchmark such as a stock index. When first devised, the funds were mostly passive, meaning your investment in the ETF would rise and fall roughly in line with the performance of the benchmark. Many still have that structure, but the ETF universe has evolved.

“An ETF can mirror an index, a commodity, bonds, or a basket of assets like an index fund,” says Patrick Smith, senior manager for trader and education marketing at TD Ameritrade.

“Unlike mutual funds, an ETF trades like a common stock on a stock exchange,” he adds. That means they can be bought and sold throughout the trading day, and prices fluctuate throughout the day. And like common stocks, many ETFs have associated options listed on exchanges. Mutual funds, in contrast, are priced and settled once a day to what’s called a net asset value (NAV).

ETFs can help investors to diversify by distributing investments across sectors, subsets of sectors, and subclasses. Some ETFs might track the S&P 500 (SPX); a specific sector, like healthcare; or a specific asset class, like small-cap stocks or international stocks. Beyond equities, there are ETFs that track commodities, and bonds, and real estate, and foreign indexes, and so forth.

ETFs Come in New Flavors

As ETFs have gained in popularity over the last decade, so, too, have the variety and sophistication of the investments. Let’s name a few:

• Equally weighted indexed-based ETF. Fund holds all the stocks in the benchmark in equal proportion.
• Market-weighted ETF. Might hold a bigger percentage of one stock in the benchmark than others, traditionally determined by market capitalization.
• Inverse ETF. Holds investments, such as derivatives, that aim for an equal-but-opposite return profile of an asset or benchmark.
• Leveraged ETF. Also uses financial derivatives and debt instruments to amplify the returns of the underlying benchmark.
• Sector- or strategy-based ETF. Although many ETFs are passive funds, some actively managed ETFs (nicknamed “smart beta funds”) have popped up in recent years. Such ETFs assess and assign a score to a number of factors, and then overweight or underweight certain stocks or sectors based on their factor scoring. Examples of factors include value, volatility, liquidity, and profitability.
• And then there are combinations—or in financial-speak, “hybrids”—of all or some of the above.

ETFs can be a low-cost way to achieve portfolio diversification, as they can avoid some of the transaction costs associated with individual stock picking or the operating costs of actively managed mutual funds. But ETF newcomers such as actively managed ETFs and smart beta ETFs generally have higher expense ratios than passive ETFs.

Fees vary across funds everywhere, whether they’re ETFs or mutual, so it’s wise to carefully read the prospectus, particularly if there are two or more ETFs tracking the same or similar indexes. And make sure the underlying securities of the ETF match what you’re looking for. TD Ameritrade offers an extensive array of commission-free ETFs.

A Tax-Efficient Choice

Like mutual funds, ETFs are subject to capital gains and taxes on dividend income. But unlike mutual funds, ETFs are comprised of what are called “creation units”—large baskets of underlying securities, weighted to match the index composition. Each creation unit is broken into tiny pieces called ETF shares, which investors can buy and sell throughout the day. Because the creation units stay in the trust (unless there is a large-scale divestment, in which case a creation unit may be redeemed by the trust), there are far fewer taxable events happening within an ETF versus a mutual fund.

The tax implications on ETFs can be complicated and vary depending on the asset class and structure, but in general, an ETF investment isn’t taxed until you sell it. But remember: taxation can be dependent on how long you held an ETF.

A Word of Caution on ETFs

Funds have been flooding into ETFs over the last several years, according to ETF.com, which follows the movement. 2016 saw roughly $287 billion in net creations, ETF.com says, and by the end of July, 2017 had already seen about $274 billion in net creations.

Some financial experts have expressed concerns that investors might be holding too many ETFs in their portfolios, with overlapping fund strategies that could negate some of the benefits of diversification. Also, some ETFs can be thinly traded, which means they may suffer from liquidity issues, especially during times of market stress.

As with any investment, read the prospectus, be aware of the risks, and remember that past performance is no guarantee of what might lie ahead.  

Information from TDA is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade.