There are numerous reasons why investors find ETFs to be 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.” It also means it is possible to short sell ETFs. Additionally, you may be able to buy ETFs using margin, just like with stocks. You can also use trading and risk-management tools, like trailing stop losses. And, like stocks, you can trade options on many ETFs (although the liquidity of ETF options varies considerably).
2. Transparency: You know what you’re getting
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 the ETF or fund will hold whatever securities comprise that index (or a representative sample). Unlike an actively managed mutual fund, the only time an indexed portfolio will change strategies is if the underlying index changes, and changes to index portfolios are typically announced well in advance.
3. Diversification: Target your level
Unlike single stocks or bonds, ETFs typically provide exposure to a basket of securities (with the caveat that some ETFs may hold only 1 type of commodity or foreign currency). By investing in multiple securities with varying degrees of correlation, ETFs offer investors assorted levels of diversification. For example, ETFs that provide exposure to the entire international stock market may have over 7,000 holdings and offer extensive diversification. Alternatively, ETFs with narrowly defined indexes and highly correlated holdings will provide less diversification.
4. Ease: Bond and commodity market investing
ETFs also provide an opportunity to invest in asset classes where the transaction costs have traditionally been prohibitively high for individual investors.
For example, bond market ETFs allow you to invest in various treasury, muni and corporate bonds, from U.S., developed international, and EM issuers. Investors also have the ability to choose between long, short, and intermediate-term securities, or in some cases, to select an ETF where all the bonds in the portfolio mature in a single year.
Similarly, ETFs provide access to the commodities markets via precious metals held in grantor trusts, futures contracts held in limited partnership, or actively managed ’40 act funds.
5. Financial advantages: Tax efficiency
ETFs are also generally more tax efficient than actively managed mutual funds. Through index-tracking, ETFs tend to have lower turnover (reducing the potential for capital gains). Furthermore, through the in-kind creation/redemption process, ETF managers are often able to transfer low-cost basis securities out of the fund in-kind to APs. This reduces the capital gains on any remaining securities that must be sold (for example, in an index-rebalancing).
At the individual investor level, it’s also possible to use ETFs as the replacement securities in tax-loss harvesting scenarios. More information about tax-loss harvesting can be found here: