A common investing question I get in my workshops is, “What are ETFs?” and “Should I consider them for added diversification?”
These are good questions and tell me more people are educating themselves about different financial instruments and that they want to know whether something makes sense for “them” and not blindly investing because everyone else at the office is what I affectionately call “lemming investing.” So let’s see if I can shed a bit of light on the two aforementioned queries.
What are ETFs (Exchange Traded Fund)?
The most simple definition of an exchange traded fund is that it is a basket of different stocks that is designed to track a specific market index, such as the S&P 500, but unlike a mutual fund ETFs can be traded at any point – like an individual stock. Much like an index mutual fund, it is passively managed which means there is no active buying and selling of individual stocks which results in a lower cost of ownership for the investor.
Now, does it make sense to own ETFs? Let’s take a look at some of the benefits.
Should you be investing in ETFs?
As mentioned earlier, ETFs can offer more diversification. Since they track individual benchmarks you can be invested in broader benchmarks such as the S&P 500 to a more specific industry or country benchmark such as biotechnology or India for example. Some other considerations may be:
- Low transaction costs. ETFs are not actively managed, so costs are generally below 1% of your investment. One thing to be aware of though is your commission costs. If you actively trade ETFs, commission costs can add up dramatically.
- Liquidity needs. ETFs can be traded as often as intra-day so there is more immediate access to your money if the need arises. (a lot of people don’t realize that mutual funds are actually only traded at day-end prices, so you can enter an order to buy or sell at any time, but it’s not executed til the market is closed)
- Ability to employ strategic trading involving option and short selling opportunities (for more experienced investors) These two strategies allow the investor to leverage their investing dollar to possibly gain a larger return. (Note: these strategies also leverage the risk factor as well!)
So at the end of the day, if you are looking for a lower cost investment where you are not throwing a dart at an individual stock, but instead buying into a benchmark which will enhance your portfolio diversification (and you seek the advantage of more liquidity), then looking into an exchange traded fund may well be worth your time.