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.
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.
ETFs do come with costs and risks, however, and it’s important to understand them before you invest.
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.
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.
Exchange-Traded-Funds (ETFs) values will fluctuate so that an investorâs shares, when sold, may be worth more or less than their original cost. ETFs trade like stocks on the open market, which in most cases involves a commission.
Investors should consider the investment objectives, risks, and charges and expenses of an ETF carefully before investing. A prospectus which contains this and other information can be obtained from your financial professional. Please read the prospectus carefully prior to investing.
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