An ETF is an investment product that tracks the performance of a stock index, bond index, commodity, or other basket of assets and trades like a stock on an exchange.
Well-selected ETFs have many benefits, including lower costs, diversification, and risk reduction.
Investors should be aware of ETFs' complexities— taxes, liquidity, credit risk, and tracking error for an ETF depends on its structure.
ETFs have their benefits and uses, but investors shouldn't take them to be a comprehensive investment strategy.
Are diamonds the next great investment? Or copper? Maybe junk bonds? Wherever your investment interest lies, there's likely an exchange-traded fund (ETF) for that. But just because an investment opportunity exists doesn't mean it's appropriate for everyone. And though ETFs can be very useful tools in building a portfolio, they still require due diligence.
Many readers know an ETF is an investment product tracking the performance of a stock index, bond index, commodity, or other basket of assets—similar to an index fund. But unlike index funds, ETFs trade like stocks on an exchange. ETFs were first launched in US in the early 1990s and have rapidly gained in popularity—and also in number and variety—over the last couple decades.
Well-selected ETFs have many benefits. They allow investors to capture a category's return without having to buy all (or most) of the category's individual stocks. Investors with smaller portfolios can use ETFs to diversify easily and efficiently at a relatively lower cost. Plus, buying an ETF can reduce stock-specific risk in a narrower category even in larger portfolios.
There are myriad ways to deploy ETFs tactically in a portfolio, but investors should also be aware of their complexities. For one, the nature of ETFs can vary. The fund might be set up as a limited partnership or a type of trust, and exchange trade notes (or ETNs, a similar investment vehicle) are actually debt securities—meaning taxes, liquidity, credit risk, and tracking error depends on its structure. For example, an investor holding SPDR Gold Shares, a gold ETF, must pay a 28% collectibles and precious metals tax on gains instead of the lower capital gains tax rate. We've also noted the potential discrepancies that can temporarily arise between bond ETFs' market prices and net asset values (NAV).
Additionally, though many ETFs offer diversification, some don't. In fact, some are intentionally narrowly focused, making them potentially useful portfolio components but not substitutes for a well-diversified portfolio. An investment is only as good as its underlying holdings, and some ETFs follow "fads" or investment "niches"—like the "talisman of magic" diamond ETF.
ETFs have their benefits and uses, but investors shouldn't take them to be a comprehensive investment strategy. Even with ETFs, investors still need to decide what to buy, when to buy, when to sell, and how much exposure is desired. And the ETF picture will likely only get more crowded as new ETF sponsors and products enter the market.
No doubt, ETF innovations will continue to meet (or create) demand. With innovation, however, comes the potential for new risks as well as rewards, heightening the importance for investors to make sure they understand what they are buying.