As an investor, it’s best to control the amount of risk added to your investments. Rather than lay your savings on a roulette wheel (chance of winning 2.63%, payout 35:1), you can mitigate risk in your portfolio. One way to do that is through exchange-traded funds, or ETFs.
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Overview of ETFs
Overall risk can be reduced through investment diversification among asset classes, corporate capitalizations, and industry sectors. Most individual investors cannot afford to own a portfolio of individual securities that achieve adequate diversification. A $4.95 stock commission on a $1,000 trade is only 0.495%, but on $100, it’s 4.95%. If you don’t have tons of money lying around, you must use mutual funds to control costs.
A mutual fund forms to gather, collect and pool investors’ available assets. With the power of large capitalization, the fund can buy diversification. A Standard and Poor’s 500 Index Fund like the Vanguard 500 Index (VFINX) allows you to own a portion of every company in the index, even if you only have $1,000. The SPDR S&P 500 (SPY) is an exchange-traded fund (ETF) that holds the same 500 stocks as VFINX, but whose shares trade like a stock on the New York Stock Exchange (NYSE). Most ETFs are indexed portfolios; they are created to track the return of a market index like the Standard and Poor’s 500. Some ETFs have active managers who adjust the contents of an ETF’s portfolio.
Pros and Cons of ETFs
Pros of ETFs
An exchange-traded fund is liquid. For a stock market commission, you can buy a portfolio of shares of common stock, know the price you paid immediately, sell the portfolio that same day and immediately know the proceeds of the sale. ETFs are known quantities.
The shares of an indexed ETF have a predetermined portfolio and are not subject to the changes by an “active” manager. The net asset value of an ETF is based on the same weightings of the same shares every day.
Cons of ETFs
ETF prices can be subject to the driving forces of the stock market. Because an ETF trades on a national exchange, its market price may not match the net asset value of the fund.
Unlike an open-end fund like VFINX, the shares of the fund may trade at a discount or premium to the value of the underlying investments the ETF holds.
Lack of liquidity at a time of a market rout could cause a smaller ETF to trade at a deep discount to its net asset value. A selling crisis could cause the shares of an illiquid ETF to trade at a greater discount to its net asset value.
Examples of ETFs
SPY was the first ETF listed in the United States and was designed to correspond generally to the price and yield performance of the S&P 500 Index. It is the largest ETF of its type, at over $250 billion in assets under management.
As with all investments, a greater risk may equal greater return. An ETF like SPY spreads risk among 500 companies. The Invesco QQQ Trust (QQQ) spreads risk among fewer companies — the NASDAQ 100 — and thereby achieves the highest returns among large-capitalization ETFs. QQQ’s expense ratio is slightly higher than other indexed ETFs but its concentration of assets into stocks of very few companies may be more worrisome.
QQQ holds over 30% of its assets in the stocks of Microsoft, Amazon, and Apple. Rather than a narrower slice of the market, Vanguard Total Stock Market (VTI) takes a broader look at the market by tracking the CRSP U.S. Total Market Index of over 3,600 companies of all sizes and industries. Even with that much more expansive scope, VTI has kept pace with the narrower indexes, stayed positive for 2018 and maintained an equally minuscule expense ratio.
Where to Buy ETFs
ETFs are available from any bank or broker that sells securities, but that does not mean that ETFs should be purchased anywhere. Commissions vary widely in the brokerage business, as does the quality of service.
Carefully select the firm you use for ETF transactions. Technical support for a securities account is like financial property and casualty insurance. When it comes time to sell, a little extra expense can mean savings through efficient trading. Also, many brokerages offer commission-free ETFs, like Ally, E-Trade, and TD Ameritrade, just to name a few.
ETFs are one step beyond mutual funds in risk and one step toward preferential control by you, the individual investor. Total return is not the only measure of performance for an investment portfolio. You must feel confident that assets are appropriately invested, and ETFs allow you to assert more influence over underlying portfolio contents without owning individual common stocks.
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