What Are ETFs?
In the simplest terms, Exchange Traded Funds (ETFs) are funds that track a specific index. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its underlying index.
ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term.
ETFs for Passive Management
The purpose of a passively-managed ETF is to match a particular market index, leading to a fund management style known as passive management. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. This is quite different from an actively managed fund, where the manager continually trades assets in an effort to outperform the market. Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks. For these reasons, ETFs mitigate the element of "managerial risk" that can make choosing the right fund difficult.
Cost-efficiency and Tax-efficiency
Because an ETF tracks an index without trying to outperform it, it typically incurs fewer administrative costs than actively managed portfolios.
Passive management is also an advantage in terms of tax efficiency. ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create capital gains distributions. Fewer trades by the manager mean fewer taxable distributions, and a more tax efficient investment.
Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies.
Buying and selling shares of an ETF will result in brokerage commissions and will generate tax consequences. Mutual funds and ETFs are obliged to distribute portfolio gains to shareholders.
Flexibility of ETFs
ETF shares trade exactly like stocks. Unlike index mutual funds, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold short, or held for the long-term, exactly like common stock. Yet because their value is based on an underlying index, ETFs enjoy the additional benefits of broader diversification than shares in single companies, as well as what many investors perceive as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs, based on major indexes, typically trade at much higher volumes than individual stocks. High trading volumes mean high liquidity, enabling investors to get into and out of investment positions more easily.
Long-Term Growth of ETFs
It was in the late 1970s that investors and market watchers noticed a trend involving market indexes - the major indexes were consistently outperforming actively managed portfolio funds.
How Do Indexes Work?
An index is a list of related securities, together with statistics representing their aggregate value. It is used chiefly as a benchmark for indicating the value of its component securities, as well as investment vehicles such as mutual funds that hold positions in those securities. Indexes can be based on various categories of securities. There are the widely known market indexes, such as the Dow Jones Industrial Average, the NASDAQ Composite, or the S&P 500. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small growth, large growth, etc.); even commodities. There are bond indexes as well.
This information is not intended to be investment advice.