There are numerous reasons why investors find ETFs to be such an attractive vehicle. Keep in mind that depending on your strategy or style, some of these may seem more (or less) applicable.
1. Familiarity: ETFs trade like stocks
This first feature was mentioned in our earlier explanation of ETFs: unlike mutual funds, ETFs trade throughout the day on exchanges. In other words, you can buy or sell them anytime the market is open, and the price goes up and down like a stock. This is known as “intraday trading.”
Why else is it important that they trade like stocks? A lot of reasons: It means you can short sell ETFs. Additionally, you can buy ETFs on margin, just like you can buy stocks. You can use trading and risk-management tools like trailing stop losses on them. And, like a stock, you can earn dividends on the underlying assets of ETFs.
2. Transparency: You know what you’re getting
Many ETFs (in fact, the majority of ETFs) are designed to track a specific index or benchmark. For example the S&P 500 index, the price of gold, or a particular international stock index. ETFs that track an index offer investors a high level of transparency, which is a good thing if you like to know exactly what you’re buying with your money.
When you buy an ETF or mutual fund pegged to a particular benchmark index, you know that the ETF or fund will hold whatever securities comprise that index. Unlike an actively managed mutual fund, the only time an indexed portfolio will change is if the underlying index changes. Changes to index portfolios are typically announced well in advance.
In terms of transparency, compare this to a typical actively managed mutual fund or ETF which has a portfolio manager who is actively buying and selling securities for the fund’s portfolio. While an actively managed fund or ETF may outperform a given index if the fund manager does a good job, in terms of transparency, the portfolio for an actively managed fund or ETF may change much more significantly than the typical indexed ETF.
In considering transparency it is also worth noting that you can typically go to the ETF sponsor’s website and view a listing of the holdings on a daily basis, while standard open-end mutual funds are only required to disclose their portfolio holdings on a quarterly basis.
3. Diversification: Increase your exposure
As with standard mutual funds, another key benefit of ETFs is that they give investors the ability to achieve diversification with just one single transaction by allowing them to “purchase an index.”
Let’s illustrate this simple concept with an example. Let’s say you want exposure to financial stocks but have only a certain amount of capital to commit. There are easily hundreds of stocks to choose from. You could go out and analyze a multitude of financial companies and try to decide which ones you think are the best and then purchase a basket of individual financial stocks to the extent that your capital allows.
Of course, this requires a lot of time, a degree of skill (in terms of fundamental and/or technical analysis); and to achieve diversification among those stocks, it will very likely require significant capital and/or time.
Therefore, a much simpler and possibly more effective alternative would be to buy an ETF pegged to a particular financial stocks index. For example, you could purchase shares of the Financial Select Sector Spyder (SPDR) Fund (ticker XLF), which holds a portfolio of over 80 individual financials stocks that are included in the index. By buying shares of XLF, not only do you get exposure to a wide cross section of financial companies, but you always know exactly what securities you are investing in.
Speaking of diversification, not only can a single ETF help give you diversification within a given sector, but with the purchase of even just a handful of ETFs you can quickly create a broadly diversified portfolio. For example, consider a simple four-ETF portfolio that consists of:
- An ETF that tracks a major U.S. Index such as the S&P 500 index.
- An ETF that tracks an index of international stocks.
- An ETF that tracks an index comprised of a basket of commodities.
- An ETF that tracks a diversified index of bonds.
By holding these types of ETFs (or similar ones), you have the ability to achieve your goal of diversification depending upon your personal circumstances.
From various indices, to different sectors, to large-cap, mid-cap, and small-cap stocks, ETFs give you the ability to easily diversify in a number of different ways.
4. Ease: Bond and commodity market investing
ETFs also allow you to easily invest in sectors of the bond market that might be difficult to trade if you were to attempt to buy and sell individual bonds. Among the primary categories are treasury, investment grade, and high yield (aka “junk”) bonds. Other bond categories include convertible bonds, international bonds, and municipal bonds.
In the bond market there are ETFs that allow you to invest in various treasury and corporate securities, with the ability to choose between long, short and intermediate term securities. Or you can simply choose to buy a broad-based bond ETF that includes different types of bonds in its portfolio. While there are many choices, the key point is that with ETFs you have the ability to focus your investments as broadly or narrowly as you see fit, all without having to select individual stocks or bonds.
Similarly, many investors never consider investing in commodities markets. While this is understandable in many cases, ETFs now offer investors the opportunity to invest in important commodities such as gold, silver, crude oil, and foreign currencies just as they would buy shares of stock. This opens up the potential for a whole new level of diversification for investors as well as a vast array of speculative opportunities for more active traders.
5. Financial advantages: Potential to reduce expenses and better manage tax liabilities
Finally, many individual investors appreciate ETFs because it gives them the potential to reduce their expenses and tax liabilities versus investing in mutual funds.
As with standard mutual funds, tax loss harvesting is possible with ETFs, particularly if you’re invested in a diverse range of assets via ETFs. It’s very likely that with a diversified ETF portfolio, some of the underlying assets may be down while others are up. It’s possible that for some of these assets that are down, a loss may be taken and then counted as an expense against your investments. It should be noted that there is a limit to how much of an expense you can take, and there are other rules that apply, too.