Investors are increasingly using ETFs (exchange-traded funds) to diversify their holdings. If you comprehend the risk/reward trade-offs, you might also want to think about it.

An ETF is a collection of assets whose shares are traded on a stock market. They blend the characteristics and potential benefits of stocks, mutual funds, and bonds. ETF shares, like individual stocks, are exchanged throughout the day at varying prices based on supply and demand. Like mutual fund shares, ETF shares represent a portion of ownership in a professionally managed portfolio.

What is an ETF?

ETFs are a form of exchange-traded investment vehicle that must register with the SEC as an open-end investment company (often referred to as “funds”) or a unit investment trust under the 1940 Act.

ETFs, like mutual funds, allow investors to combine their money into a fund that invests in stocks, bonds, and other assets, in exchange for a return on their investment. ETF shares, unlike mutual funds, are traded on a national stock exchange at market prices that may or may not be the same as the ETF’s net asset value (“NAV”), which is the value of the ETF’s assets minus its total liabilities divided by the number of outstanding shares.

Advantages of ETFs

Tax Assumptions

Compared to mutual funds, ETFs have two significant tax advantages. If you buy a mutual fund, you may have to pay capital gains taxes (earnings from selling an asset, such as stock) for the rest of your life. This is because mutual funds move assets more often than ETFs, mainly actively managed funds. The majority of ETFs, on the other hand, only incur capital gains taxes when sold. As a result, you’ll pay less tax overall on your ETF investment.

The investor may be subject to both long-term and short-term capital gain since mutual fund managers actively buy and sell investments, incurring capital gains taxes along the way.

Market Accessibility

ETFs have paved the way for ordinary retail investors to have exposure to asset classes formerly unavailable to them, such as emerging market stocks and bonds, gold coins or other commodities, the foreign exchange (FX) market, and cryptocurrencies. Because an exchange-traded fund may be sold short and margined or leveraged, it can allow complex trading methods to be used. 

Transparency

Compared to ETFs, hedge funds or mutual funds function less transparently. Hedge funds, investment firms, and mutual funds typically declare their holdings once a quarter, keeping investors in the dark about whether the fund is sticking to its stated investment plan and managing risks appropriately.

Diversification

While it’s natural to think of diversity in broad market verticals such as stocks, bonds, or a specific commodity, ETFs also allow investors to diversify across horizontals such as industries. Buying all of the components of a particular basket would cost a lot of money and time, but an ETF may bring those advantages to your portfolio with a single click of a button.

Diversification can help protect your investments from market fluctuations. If you only invested in one industry and that industry had a challenging year, your portfolio is likely to have suffered as well. Your portfolio will be better balanced if you invest across multiple sectors, business sizes, locations, and other factors.

Liquidity

ETFs are much more liquid than mutual funds that can only be purchased or sold at the end-of-day closing price since they may be bought or sold in online marketplaces during the day. They often trade around their real Net Asset Value because their creation/redemption process regularly balances out pricing arbitrages, bringing the price of ETF stock back to fair value.

Conclusion

Don’t put money into something you don’t comprehend. If you can’t describe the investment opportunity in a few lines and in a way that everyone can understand, you might want to reconsider investing.

Finally, you might want to consider receiving investment advice from a specialist. If you do, deal with someone familiar with your investing goals and risk tolerance. Your financial advisor should be familiar with sophisticated products and be prepared to describe whether they are a good fit for your purposes.