An ETF, or exchange-traded fund, is a type of investment fund that holds a collection of assets, such as stocks, bonds, commodities, or currencies, and trades on an exchange like a stock. ETFs have become increasingly popular in recent years and as of 2021, there are over 7,000 ETFs available globally with over $7 trillion in assets under management.
One of the key features of ETFs is that they offer the diversification of a mutual fund, but with the ability to buy and sell shares throughout the trading day, like a stock. This means that ETFs can be a useful tool for both long-term investors and those looking to make more tactical trades.
ETFs are created when an issuer, such as a bank or asset management company, brings together a group of assets and then divides them into shares. These shares are then sold to investors on an exchange. The value of an ETF is determined by the value of the underlying assets it holds.
For example, the SPDR S&P 500 ETF (SPY) holds shares of the 500 largest companies in the United States and is designed to track the performance of the S&P 500 index. Similarly, the iShares MSCI EAFE ETF (EFA) holds shares of companies in developed markets outside of the United States and Canada and is designed to track the performance of the MSCI EAFE index.
One of the main benefits of ETFs is that they offer diversification in a single investment. By buying shares in an ETF that holds a broad range of assets, investors can reduce their risk by spreading their money across multiple assets. This is particularly useful for those who may not have the time or expertise to research and select individual stocks or bonds. According to a study by Morningstar, a diversified portfolio of ETFs has historically been less volatile than a portfolio of individual stocks.
ETFs also tend to have lower expense ratios than actively managed mutual funds, which can save investors money in the long run. The average expense ratio for an ETF is 0.44%, whereas the average expense ratio for an actively managed mutual fund is 0.91%. Additionally, because ETFs trade on an exchange, they can be bought and sold throughout the trading day, giving investors more flexibility and control over their investments.
On the other hand, one of the drawbacks of ETFs is that they may not always perform as well as a focused, actively-managed portfolio. Additionally, because ETFs are created and managed by third parties, there is a risk of issuer default or mismanagement.
ETFs can be a useful tool for both long-term investors and those looking to make more tactical trades. They offer diversification in a single investment and tend to have lower expense ratios than actively managed mutual funds. However, it’s important to be aware of the potential drawbacks and to carefully research ETFs before investing. It’s also worth mentioning that ETFs are not suitable for every investor and it’s important to consult with a financial advisor before making any investment decisions.