As the leisure time of winter break has passed, it is time for some financial literacy. This week’s focus is exchange-traded funds (ETFs). The ETF phenomenon began in the 1980s, but only within the past ten years did ETFs grow in popularity. ETFs, however, are still a relatively new concept and widely misunderstood.
Walter Updegrave of CNN/Money defines the ETF: “Exchange-traded funds (ETFs) are baskets of securities, often meant to mimic a market index, that are traded on national stock exchanges and available through any broker. They combine the benefits of open-end index mutual funds—diversification with low operating costs and potential for tax-efficiency—with the trading flexibility of individual stocks.”
A stock market index, like the S&P 500, NASDAQ Composite, and the Dow Jones Industrial Average, is a specific list of related stocks. The index represents the related stocks’ aggregate value and acts as a benchmark for valuing its component stocks. The ETF tracks the performance of a stock and bond index or other benchmark (such as a commodity) in both U.S. and foreign markets. Furthermore, ETFs can track an entire stock market or one particular segment like large, small, value, growth or industry stocks.
More specifically, individuals utilize brokers within the secondary market where larger institutions either create or redeem shares through similar transactions in the primary market. Like an index fund, there is no tax impact for trading ETFs, and the bid spreads are usually close to the net asset value (NAV).
There are a number of benefits to holding such funds. One may harness the market and reduce managerial risk through the passive management of ETFs. Only periodic adjustments are made to ETFs once they are issued. Passive management combined with tax efficiency also makes these funds cost-efficient. There are lower administrative costs and lower capital gains taxes from reduced trading. ETFs also offer flexibility since they trade continuously throughout the trading day like individual stocks. High trading volumes result in increased liquidity; investors easily buy and sell into an investment position with little risk and expense. When compared to holding individual securities, ETFs’ broad diversification decreases risk.
If one has a few pennies to spare, one should consider investing in an ETF. Certain benchmark criteria aid investors in finding their best-suited ETF among the plethora of options. Investors interested in ETFs must follow the buy-and-hold strategy. Only in the long term do major indexes outperform actively managed portfolios. Other important considerations include determining the market, segment or sector to track, selecting funds with low expense rations and choosing fund managers with a consistent track record of performance. In the long term, investors may benefit from holding an ETF because of the low expense ratios and trading costs.