Q: I’ve been reading a lot about ETFs lately. It seems like they are becoming more and more popular. But there are so many of them to choose from, it’s a bit confusing. What are your thoughts?
A: For those unfamiliar, ETF stands for exchange-traded fund. And you are correct — they have become very popular in recent years. Here are a few important considerations to help decide if ETFs may be a good fit for you.
ETFs provide liquidity, flexibility and cost-efficient exposure to a broad range of asset classes, making them a good fit for many investors. But that doesn’t mean they are an appropriate choice for all investment scenarios. Investors who are considering adding one or more ETFs to their investment mix may want to first take a careful look at their own personal situation, investment style, level of knowledge and time horizon to determine whether an ETF fits in with their overall investment strategy.
Frequent traders, think twice
ETFs are best described as a basket of securities that attempt to track a particular group of securities on an index. Although one of the key attractions of ETFs is low cost, keep in mind that every time you buy or sell shares of an ETF, you must pay a sales charge, or commission. For investors who trade frequently, these sales charges could easily erase any cost advantage. Similarly, if you are likely to be dollar-cost averaging with periodic payroll deductions, or tend to invest sporadically with small amounts of money, you would probably be better off investing in a regular mutual fund.
But if you aren’t a “frequent trader,” then there are a number of situations in which ETFs may be a sound investment choice.
— Investing a substantial lump sum. If you inherit a sizeable sum, receive some other windfall or have transferred assets from a former employer’s retirement plan to a rollover IRA, the low expense ratios of ETFs will go far toward offsetting the one-time brokerage commission if you follow a long-term, “buy-and-hold” strategy. — Investing outside of a tax-sheltered plan. When investing in a regular taxable account, ETFs could save you money at tax time. Since ETFs sell on an exchange, like stocks, most trading takes place between individual shareholders. As such, the fund manager is not forced to sell shares to raise cash. This helps ETFs keep their potential capital gains exposure much lower than it would be otherwise. — For knowledgeable investors. If you are an experienced investor who enjoys focusing on specific industries or on particular regions or countries of the world, ETFs may offer a more cost-efficient way to pursue these types of market opportunities than would single stocks or sector mutual funds.
This investment could help
If you feel the time is right to take a closer look at ETFs, contact your financial advisor to discuss the many ways that ETFs can be used to potentially enhance your portfolio’s risk/return profile. ETFs can be used:
— To enhance diversification. The ever-increasing variety of ETFs available offers an easy, cost-effective way to provide a degree of diversification that would otherwise be too time-consuming and expensive to attain. — As hedging tools. Since ETFs share many of the trading characteristics of stocks, they can be used as effective portfolio-hedging tools. For instance, with ETFs, investors can specify limit prices, enter stop orders and even use other strategies to protect portfolio principal or to enhance portfolio return. — As a secondary portfolio. For investors with a primary portfolio made up of traditional equity and fixed-income investments, a secondary portfolio made up of carefully chosen ETFs can be constructed and occasionally rebalanced to maintain predetermined weightings. — As a substitute for cash. ETFs can be used as a transitional investment vehicle, a way to make use of cash that has been moved out of a mutual fund or other investment due to ordinary or transitional management reasons.
ETFs are gaining in popularity with all types of investors, from long-term investors seeking lower operating costs and lower capital gains taxes to active investors seeking hedging and cash-flow strategies. But with the growing range of ETFs available, and with so many strategies for using them, investors should exercise caution before investing.
ETF prices change throughout the trading day, and investors may not be able to realize a quoted price. Purchase and sale of ETF shares may involve brokerage-trading commissions that are not typically included in the ETF expense calculations. The frequent trading of ETFs could significantly increase costs such that they may offset any savings from low fees or costs. An investment in an ETF is subject to the risks of its underlying investment holdings and of losing money and should be considered as part of an overall program, not a complete investment program. Additional risks of ETFs include lack of diversification, price volatility, competitive industry pressure, international political and economic developments, possible trading halts and index-tracking errors.
Mutual funds are offered with a prospectus. Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read the prospectus carefully before investing.
Foreign investments involve greater risks than U.S. investments, including political, economic and currency fluctuations, and may not be suitable for all investors.
There is no guarantee a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.
This article was prepared with the assistance of McGraw-Hill Financial Communications and is not intended to provide specific investment advice or recommendations for any individual. Consult a financial advisor if you have any questions. LPL Financial, Member FINRA/SIPC. *Based on total revenues, as reported in Financial Planning Magazine, June 1996-2010.