ETF stands for exchange-traded fund. To keep things simple, you can think of it like mutual fund that can be traded like stock. It is made up of a basket of securities and experiences changes in price throughout the day as it is bought and sold. In general, an ETF will trade at the same level or very close to the net asset value of an underlying asset. But because you can trade it like stock, its own net asset value is not calculated every day, opposite of how it applies to mutual fund.
What sets ETFs apart?
Owning ETF lets you enjoy an index fund’s diversification while selling short, buying on margin, and purchasing as little as just a single share. With ETF, you also take advantage of lower expense ratios that what you would get from ordinary mutual fund. Whenever buying and selling an ETF, you also have to pay your broker the same kind of commission you would on a regular order.
Reasons for investing in ETFs
To make the most out of investing in anything, you have to beat the market. However, that would be very difficult to do if you’re investing in actively-managed mutual funds or picking individual stocks. Actually, the cold hard truth is that it’s next to impossible to beat the market. So if you can’t beat the market, the next best thing you can do is to match it and you can do that by using index ETFs.
Consider the following arguments to shed light on what investing in ETFs would be like for you:
- ETFs versus actively-managed mutual funds. Since most ETFs out there are indexed, this ensures that they, on average, will perform better than their actively-managed mutual fund counterparts. In addition, no minimum investments are set, short-selling and options opportunities exist, lower taxes are imposed, trading is flexible, and there is more transparency with ETFs.
- ETFs versus picking individual stocks. You get to take advantage of diversification with ETFs compared to picking individual stocks, much like mutual funds, and that’s generally what investors need, reducing your risks without affecting returns over time. You also end up just making one transaction with an ETF so you also get to save on broker’s fees.
- ETFs versus index funds. Index ETFs are superior to actively-managed mutual funds but how do they fare compared with their index fund (index mutual fund) counterparts? They aren’t actively managed and they have expense ratios lower than mutual funds that are actively managed, making index funds still a reasonable means of buying the market and keeping trading and management costs down. A lot of investors though choose ETFs instead of index funds because the former doesn’t call for minimum investments and allows intra-day trading, making it the more convenient choice.
Building an ETF portfolio
An investment portfolio generally represents your collection of investments. In the case of an ETF portfolio, it shows your investments regarding ETFs, like which ETFs have your money. When building an ETF portfolio, take note of your investment horizon (the amount of time you expect to have the investment), your goal (why are you investing—is it for a house, your retirement, etc?), and the level of risk you are willing to face (which generally depends on your age; for instance, being young gives you more time to make up for losses on investments so it’s a good time to be riskier). As with any kind of portfolio, your ETF portfolio should be diverse, following the “110 – age” rule for equity holdings. This means that if you’re 35 years old, your investments should be 75% stocks and 25% bonds.