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Exchange-traded funds (ETFs) are a popular investment vehicle due to their broad diversification, wide availability and relatively low costs. These investments, which you can purchase through a brokerage or retirement account, include a basket of stocks or other securities to help diversify your portfolio.
ETFs can be an integral part of your investment strategy, but it's wise to review their advantages and disadvantages before proceeding. Here's what you need to know to help you determine if you should invest in ETFs.
Advantages of ETFs
Whether you are looking to diversify your portfolio or grow your wealth, investing in ETFs may benefit you in several ways.
Greater Trading Flexibility Than Mutual Funds
Traditional mutual funds only trade once a day after the markets close, and all trades are made through the mutual fund provider. That means you won't know how much you paid or received for the shares you traded until the fund releases its net asset value (NAV) at the end of the day.
While this type of once-daily trading is sufficient for most long-term traders, you may prefer the trading flexibility ETFs offer. You can buy and sell ETFs during normal market exchange hours. The price you'll pay or receive for shares is based on its current market value at the time of the trade, which fluctuates throughout the day. When you invest in an ETF, you'll immediately know how much you paid or received for the shares you traded.
This flexibility allows you to make timely investment decisions throughout the day if necessary. Also, ETFs allow you to make the same types of trades as common stocks, including limit orders, stop-limit orders, options and short selling.
Broad Portfolio Diversification
Another significant benefit of ETFs is the diversification they bring to your portfolio. When you buy into one fund, you gain access to stocks from multiple companies. Many ETFs specialize in specific equities, industry sectors, bonds and currencies, which can help diversify your portfolio, especially if you're not an expert in these areas.
You can trade ETFs on nearly all major asset classes, commodities and currencies. Additionally, international, regional and industry-focused ETFs may be easier to invest in than buying individual stocks and bonds.
Generally, ETFs offer lower average costs than if you were to buy all the individual stocks held in an ETF. When you buy an ETF, you automatically gain access to all the holdings in the fund, and similarly, it only takes one transaction to sell the fund. By making fewer trades, you may realize significant savings in broker commissions. You may even find a broker offering low- or no-commission trades with some ETFs, providing another opportunity to save.
Some ETFs have lower expenses because they track an index. For instance, if you invest in an ETF that tracks the Nasdaq 100, the fund might include all 100 financial companies from the index. These "passive" ETFs require less time and resources from fund management, often resulting in lower operating expenses for ETF investors.
Disadvantages of ETFs
While the advantages of ETF investing are substantial, they're not without downsides. Consider the following drawbacks before buying an ETF.
Higher Management Fees
Not all ETFs are passive. Some ETFs are actively managed, meaning they're managed by a fund manager whose goal is to outperform the market. Actively managed funds often have higher fees since they require management to guide the fund. These higher fees can offset your returns over time, especially if the ETF underperforms.
Financial services firm Morningstar notes that the average investor fee has been declining for over two decades. The asset-weighted average expense ratio of U.S. open-end mutual funds and ETFs was down to 0.37% in 2022, substantially lower than the 0.91% average expense in 2002. However, the fees for actively managed ETFs remain relatively higher, with an average expense ratio of 0.69%, according to ETF.com.
Less Control Over Investment Choices
When you invest in an ETF, you're buying a basket of stocks intended to align with the fund's objectives. However, the fund's goals may not match your own investment preferences.
As a result, your fund may include companies or sectors you may not want. In this case, you have less control over your investments in the ETF than buying and selling individual stocks and bonds.
May Not Beat Individual Stock Returns
While ETFs can help you gain diversified exposure to a specific sector, commodity or index, these funds may provide lower returns than individual stocks. For example, you may be able to beat a broad-market ETF with a portfolio of individual stocks, especially if you have the time and expertise to manage your investment wisely.
You might think of ETFs as a balancing act: They provide diversification, which reduces risk, but they can also dilute potentially high returns.
Should You Invest in ETFs?
Deciding whether to invest in ETFs depends on many factors, such as your investment goals, preferences and risk tolerance level. ETF investing may make sense if you're looking for more trading flexibility than traditional mutual funds offer, including the ability to execute trades during market hours and receive immediate confirmation of the transaction value.
ETFs are also a good option if you want to diversify your portfolio with a single transaction that provides you with a variety of stocks across different companies, sectors, currencies and even countries in a cost-effective way.
On the other hand, investing in ETFs may not be your best option if you prefer having more control over your investment choices. In that case, choosing your own individual stocks may suit you better than purchasing an ETF with an already established collection of stocks and bonds. Similarly, if you're aiming for higher potential returns and have the time and knowledge needed, selecting individual stocks may provide a better path to achieve your investing goals.
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How to Invest in ETFs
You can start investing in ETFs by opening a brokerage account, preferably one that offers commission-free ETF trades. Next, fund your account so you purchase an ETF when you find the right one that meets your needs.
If you're new to investing, consider opting for an ETF that tracks an index, such as the S&P 500 or the Nasdaq 100, as they tend to have lower costs while providing you with a wide variety of stocks. If you have more experience or specific investment goals, you might consider a more specialized ETF. Remember, there is a wide variety of ETFs to choose from that specialize in specific industries, countries, equities, bonds, commodities and other segments to suit your needs.
Whatever ETFs you choose, it's essential to do your due diligence or consult a financial advisor to ensure they align with your overall investment portfolio and long-term financial goals.
The Bottom Line
ETFs offer portfolio diversification, lower expense ratios and trading flexibility, but they're not your only option. You can personalize your portfolio with individual investments in stocks and bonds or invest in mutual funds for similar diversification with professional management. Investing in real estate or commodities is also an option.
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