Today, I will touch upon exchange traded funds or often shorten to ETF’s. You may have heard this while reading through an article or heard someone mention that they’re investing in one. So what the heck are they?
Investopedia defines an exchange traded fund as “A security that tracks an index…[and] trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.” Let’s understand a couple terms before we proceed so we can fully understand the concept.
Security – this is something that is openly traded on the stock market. This can be a stock, like IBM, or a bond, like a U.S. Treasury. The price of the security is dictated by market participants (investors like you). The more people willing to buy a security will usually increase the price. Securities can be purchased throughout the day at whatever price there is a willing buyer and seller.
Index – A bundle of securities packaged together to represent a particular market. You may have heard of the Dow Jones Industrial Average or the S&P 500. These are both indexes and used as benchmarks. When we hear that the S&P 500 is up 3% we know that the U.S. market had a good day. Indexes are a way for us to understand how we are doing in comparison. Now there are many other indexes out there that track different types of markets. There are indexes for bonds, international markets and many others.
So, if we tie this back an exchange traded fund is an investment, like a stock, but they track an index. Advisors utilize ETF’s as a way to gain diversification in portfolios at a minimal cost. Many investors choose ETFs because they know investors returns are mostly do to what asset classes you are invested in and not specific mutual funds or stocks you hold. Active mutual fund managers may cause portfolios to be too aggressive or too conservative because of the way they move in an out of stocks. Fees are also higher and most often they can’t beat their benchmarks. There are also some tax benefits to using ETFs in a taxable account as opposed to mutual funds (this is a little more technical than we need to get).
So do you incorporate ETFs in your portfolio? Why or why not?
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