The elusive exchange-traded fund (ETF): You've probably heard about them. Maybe you’re even intrigued. So what's all the hype about? The Fidelity Viewpoints® article "Inside ETFs" explains what they are, how they work, and how you can use them as part of your investing strategy.
ETFs: What are they exactly?
ETFs are a type of investment made up of stocks, bonds, or commodities. While they typically track—or try to match the performance of—a market index, like the S&P 500, there are types of ETFs that try to outperform the market, and others that offer exposure to niche parts of the market. ETFs allow you to invest in a bunch of different securities, and they trade a lot like stocks in that they can be bought and sold at different prices from market open to market close. Simply put, ETFs can offer the diversification of a mutual fund and the trading flexibility of a stock.
So, what are some of the benefits?
- Low cost.
Most ETFs are passively managed (meaning, they aren't managed by a fund manager), and tend to have lower operating costs compared to actively managed funds (which are managed by a fund manager). This is because passively managed funds attempt to track a market index or a benchmark, so there’s no need to pay a fee for a fund manager’s expertise in selecting the fund’s investments. Keep in mind that you will pay commissions when you buy and sell ETFs, and there may be other hidden costs associated with them. These fees are super important to understand, so bear with me as we get into the weeds a little.
There's generally a difference between the price at which you can buy shares of an ETF, and the price at which you can sell it. This difference is called the "bid-ask spread." Here's why it's so important: If you’re the type of investor who trades frequently and places large orders with wide spreads, the impact of the bid-ask spread could hit you harder than you originally thought. That’s why it’s important to pay close attention to fees when it comes to ETFs, and make sure you know what you're paying for.
One of the main benefits of ETFs is that many invest in a portfolio of securities (like stocks, bonds, etc.). They also come in a wide variety of flavors, and can be an effective way to make more targeted investment decisions. Interested in investing in gold? There's an ETF for that. Solar energy more your style? Coming right up. Because ETFs invest in a portfolio of securities, some investors may find them more attractive than hand-picking individual stocks, which can be more time-consuming, more expensive, and more complicated. Similar to stocks and bonds, you'll still want to do your research to understand the risks and investment approach of any ETF you are considering.
- Flexible trading.
Like stocks, ETFs can be bought and sold at any time throughout the trading day, which can be an advantage in fast-moving markets. By contrast, mutual funds can be bought or sold based only on the net asset value (NAV), which is typically determined once a day, at the end of the trading day. What you also might not know is that ETFs have low investment minimums, meaning you can buy as many shares of an ETF—or as few—as you like. But here's where it gets tricky: While mutual funds trade at their NAV, ETFs trade like stocks, meaning you buy and sell shares at a price determined by supply and demand. Depending on the state of the market, ETFs can trade at a market price above or below the NAV—which is called a "premium" or "discount," respectively. Depending on when you buy and sell the ETF, you’ll want to be aware of the risks associated so you don’t take a major hit.
Mutual funds typically only publish their "holdings" (or, the securities that make up the fund) every one to three months, while ETFs report individual holdings daily. The advantages? You can see exactly what you own at any given time, which can help identify any holes or overlap in your portfolio. Watch out for risks associated with actively managed ETFs, discussed in more detail here.
- Tax efficient.
Mutual funds and ETFs are both required to pay capital gains to shareholders annually. But because ETFs closely track an index, they tend to have low trading activity, and, therefore, fewer capital gains than actively managed mutual funds. ETFs also tend to be more tax efficient thanks to something called a "creation and redemption," which basically allows ETFs to trade based on supply and demand. It can be complicated, but there's a helpful (even fun!) video about creation and redemption on the Fidelity Learning Center. Watch it here.
ETFs sound pretty good. Any disadvantages?
- Most ETFs don't give you a chance to outperform the market.
Which is one of the benefits of actively managed mutual funds.
- Watch out for brokerage costs and risks.
Just because you can trade ETFs throughout the day doesn't mean you should. The costs associated with buying and selling ETFs can erode their cost advantage.
- Make sure you know what you're getting.
With more than 1,400 types of ETF out there, you'll want to be sure you understand the cost implications and risks associated with the one you've selected.
- Be cautious of specialized funds.
Some ETFs are designed for very aggressive, sophisticated investors who monitor and manage their investments on a daily basis. "Leveraged" and "inverse" ETFs are two examples that you may have heard of. If not managed appropriately, these types of funds can expose you to significant risk.
THE BOTTOM LINE:
ETFs have their pros and cons—but with more than 1,400 to choose from, make sure you do your homework.
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