Market volatility like we’ve experienced this year can be disconcerting for even the most seasoned investor.  This volatility has reignited debate in the investment industry about whether active or passive investing is the way to achieving the best returns.  Active investing is using a manager to assess investment opportunities with a goal of beating the return the market gives you.  Passive investing is investing in a basket of securities chosen to mimic an index.  Exchange Traded Funds, or ETFs, are at the center of this debate.  Today we are going to discuss ETFs and the role they can play in an investment portfolio.

The first Exchange Traded Fund, the S&P 500 Depository Receipt (SPDR, pronounced “Spider”), was launched in January of 1993.  From those humble beginnings, the ETF industry has grown to over 8,500 funds with over $10 trillion in assets. (Sources: Statista and ETF.com)

ETFs offer several advantages over other investment vehicles.  Like mutual funds, they offer easy diversification, especially for investors with smaller portfolios.  ETFs are often designed to mimic an index, and as such, proportionally invest in all the securities that the index invests in, often numbering in the hundreds or thousands. They can also be used to gain exposure to particular areas of the market, such as sectors or geographic regions. Exchange Traded Funds are usually fully invested, without any significant cash position, and may be less prone to drifting from their investment objective than traditional funds.

Because ETFs are exchange traded, they offer flexibility not found in traditional mutual funds.  ETFs can be traded throughout the day, rather than purchased or redeemed at the end of the day.  This gives investors the ability to take advantage of intraday price movements.  In addition, ETF shares can be purchased on margin, can be sold short, and give investors the option of using stop-loss and limit orders.

Because many ETFs are passively managed, they tend to have lower expenses than traditional mutual funds.  Actively managed mutual funds employ managers, and often large teams of analysts and traders, to make investment decisions.  ETFs seldom make changes to the portfolio, especially if they are designed to track an index.  ETFs are purchased like a stock, either for a commission, or as part of fee-based strategy, eliminating the share classes and load types associated with traditional mutual funds.

Lower expenses aren’t the only benefit to less frequent trading. Lower portfolio turnover also means fewer realized capital gains. This tax-efficiency may help to give you more control over your tax bill.  Of course, when you sell shares of an ETF, you may incur a capital gain or loss.

Exchange Traded Funds can help you construct your portfolio by giving you broad, diversified exposure to market segments and can be great components in an asset allocation program.  You can also use ETFs to help balance your portfolio among market sectors.  For example, if you need exposure to healthcare or to emerging markets, there are ETFs that will give you that specific exposure.  

ETFs are not perfect, but they do have some key benefits that can help to build the portfolio you want.  

To hear the podcast of the Smart Money Management radio show on this topic, or others, go to our website at alderferbergen.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Asset allocation does not ensure a profit of protect against loss.

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