Do they belong in your portfolio?
Article Courtesy of Nancy Harris, CMFC, CDFA
President, LPL Financial Planner, New Foundation Wealth Group
Exchange-traded funds (ETFs) have become increasingly popular since they were introduced in the United States in the mid-1990s. Their tax efficiencies and relatively low investing costs have attracted investors who like the idea of combining the diversification of mutual funds with the trading flexibility of stocks. The proliferation of ETF choices means they can now be used to create a broad portfolio of core investments, to target narrower sectors, or to gain market exposure that might otherwise be too difficult or costly to access. They are also being used to implement more sophisticated investment themes and strategies.
What is an ETF?
Like a mutual fund, an exchange-traded fund pools the money of many investors and purchases a group of securities. Like index mutual funds, many ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, both index mutual funds and ETFs attempt to replicate the performance of a specific index.
However, a mutual fund is priced once a day. The fund's net asset value (NAV) is calculated based on the value of the underlying securities when the market closes. If you buy after that, you will receive the next day's closing price. By contrast, an ETF is priced throughout the day and can be bought on margin or sold short — in other words, it's traded just as a stock is. But an ETF can trade at a price that's higher or lower than its NAV (a premium or a discount) due to supply and demand.
How to evaluate an ETF:
1. Look at the index it tracks. Understand what the index consists of and what rules it follows in selecting and weighting the securities in it. Be aware that the performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in any index.
2. Look at how long the fund and/or its underlying index have been in existence, and if possible, how both have performed in good times and bad.
3. Look at the fund's expense ratios. The more straightforward its investing strategy, the lower expenses are likely to be. An index using futures contracts is likely to have higher expenses than one that simply replicates the S&P 500.
Before investing in an ETF or mutual fund, carefully consider its investment objectives, risk, fees and expenses, which can be found in the prospectus available from the fund. Read the prospectus carefully before investing.
All investing involves risk, including the possible loss of principal, and there can be no assurance that any strategy will be successful.
ETFs can fill a unique role in your portfolio, but you should consider how they work and the differences among the dizzying variety of ETFs now available. Fortunately, we can help you decide how ETFs might fit your overall investing strategy.
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