Exchange-traded funds (ETFs) offer a flexible, inexpensive and tax-efficient tool individual investors can use to diversify their portfolios. Those qualities explain why the funds have continually gained in popularity since their 1993 debut, according to Professor James DiLellio of the Graziano School of Business and Management at Pepperdine University.
“They provide a level of efficiency in the market that wasn’t there before, so we’re still seeing a lot of growth,” DiLellio says.
But DiLellio cautions that while ETFs can be useful, they don’t make sense for everyone—and investors should be aware of their costs and risks.
What is an ETF?
An ETF combines features of an index mutual fund and an individual stock. Like an index fund, an ETF owns a basket of securities based on market benchmark, such as the S&P 500. But ETFs differ from mutual funds in an important way: They can be traded throughout the day, just like individual stocks. Mutual funds are priced and traded only after the market closes each day.
Like mutual funds, ETFs offer the ability to hold in many securities with a small investment, providing a convenient, cost-effective way to diversify a portfolio. They’re also inexpensive to own, especially since many large brokerage houses offer ETFs that trade commission-free, says DiLellio.
In addition, most ETFs are designed to help avoid realizing taxable capital gains—meaning they may help reduce the tax bite for investors who hold them in taxable accounts.
Costs and risks
ETFs do come with costs and risks, however, and it’s important to understand them before you invest.
- Commissions. Many ETFs trade commission-free, but check before you buy. If your ETF isn’t one of them, commission charges can diminish your return every time you make a trade.
- Expense ratio. An ETF’s expense ratio—the money taken from your assets to cover the cost of operating the fund—also eats into your total return. ETFs generally have very low expense ratios, but in some cases, the ratio might be lower on a mutual fund tracking the same index.
- Premiums and discounts. The price of an ETF can stray from the actual value of the assets in it. If the ETF is priced higher than its net asset value, it’s trading at a premium. If the ETF is priced lower, then it’s trading at a discount. Premiums and discounts aren’t much of an issue on ETFs that track major indices, but can get as high as 3% or more on niche-oriented funds.
Say you buy an ETF at a 2% premium and its price shifts to a 2% discount by the time you sell it: The change will reduce your return by four percent.
- Temptation to trade. You can buy ETFs tracking almost any corner of the market, from aluminum to nanotechnology companies, and you can jump in and out of them at will. Trouble is, frequent buying and selling is often counterproductive for the typical investor.
A better approach: Build a diversified portfolio that suits your time horizon and risk tolerance, and stick with it over time. “Individuals should typically lean toward long-term investing with ETFs,” says DiLellio.
A financial advisor can help you decide whether ETFs are a good choice for you, and can work with you to fit them into a portfolio that suits your needs.