Exchange-traded funds (ETFs) are an increasingly popular class of funds that trade like stocks. They can be bought and sold throughout the market day and offer portfolio exposure to many of the world's leading indexes. In recent years, they have gained popularity among both buy-and-hold investors and active traders. In this section you'll find information and commentary to help you use ETFs in your portfolio.
As ETFs continue to grow in popularity, you may be wondering if there's a place for this type of investment in your own portfolio. Below are some common questions from investors who are new to ETFs.
When you invest in an ETF, you're investing in a basket of securities that provides exposure to a particular segment of the market, such as a broad market, sector or geographic area. Generally, ETFs track indexes. ETFs are popular among investors because they are an easy and low-cost way to quickly build a well-diversified portfolio.
Mutual funds are purchased or redeemed directly with the fund one time each market day, at the close of the market. While you can place an order to buy or sell earlier in the day, your order will be processed only at the end of the day. The price you pay for your mutual fund is based on the Net Asset Value of the fund, determined by the day's closing prices of all the securities within that fund (plus any applicable sales charges, or loads).
An ETF trades much more like a stock. It's traded on a stock exchange, and you can buy or sell shares at any time during the day. The price is determined by supply and demand for the ETF in the market. Just as with stocks, you typically pay a commission for each trade. An exception is Schwab ETFs™—which can be traded commission-free by Schwab clients online through their Schwab accounts.
The bottom line: ETFs offer diversification with the trading flexibility of a stock.
Their costs are often low. ETF expense ratios are generally low (although there are exceptions).
They're more diversified than individual stocks. Because ETFs represent a basket of securities rather than a single stock, they provide more diversification, and investment risk is not concentrated on a single holding.
They represent almost every asset class. That's good news if you're looking to broadly diversify across asset classes or if you're looking to fill a niche in your portfolio. ETF asset classes include large-cap, mid-cap, and small-cap stocks; growth stocks and value stocks; domestic, international, and emerging market stocks; sectors; long-term, mid-term, and short-term bonds; real estate; currencies; commodities, and more.
They can be traded any time during the market day. ETFs allow you to take advantage of opportunities that occur during the day. Unlike traditional mutual funds, you don't have to wait until the markets close for your trade to be completed.
They offer potential tax benefits. Unlike mutual funds, ETFs don't sell their holdings to satisfy shareholder redemptions. This can keep capital gains low. And since most ETFs track indexes, their holdings tend to have less turnover, which further reduces distributions.
Their holdings are transparent. ETFs make their holdings publicly available on a daily basis. This can be help investors to understand exactly what they hold.
As you think about investing in ETFs, be aware that:
Market risk is always a consideration. Just like any other investment, you can lose money in ETFs if the market that they track experiences a downturn. Though you can't eliminate this risk, you can help mitigate it by investing in a mix of ETFs in different asset classes, such as domestic stocks, international stocks, and bonds.
Some ETFs are high risk. Leveraged ETFs and ETFs that are narrowly focused may be more volatile than traditional ETFs.
Investors generally pay a commission for every trade. Unlike no-load mutual funds, ETFs have a trade commission. If you are dollar-cost averaging, making small investments, or trading frequently, ETF commissions can take a big bite out of your investment. Schwab ETFs are an exception; Schwab clients can trade them commission–free online through their Schwab accounts.
Not all ETFs are low cost. Although many ETFs have low expense ratios, some do not. Be sure to check the expense ratio of any ETF you are considering as an investment.
Market price and net asset value are not always equal. The price you pay for an ETF will generally be close to the value of the underlying stocks or bonds in the fund; the net asset value (NAV). However, the market price can deviate from the NAV, meaning you might pay more (or less) than the underlying value per share. This is more common in ETFs that have low trading volume. It's generally a good idea to check both the NAV and the price when evaluating an ETF for purchase.
There is a spread between the bid price and the ask price. There is typically a difference, or spread, between the bid price (highest price a buyer is willing to pay for a share) and the ask price (lowest price a seller is willing to accept for a share). The amount of the spread varies from one ETF to another, and tends to be higher for ETFs with low trading volume. Since this spread is a part of the overall costs of investing in ETFs, it's something to take into consideration when evaluating funds for purchase.
ETFs are available in several different types:
ETFs commonly track broad-based market indexes. These are what most investors have in mind when they think of ETFs—they tend to be low cost, highly diversified, and highly liquid.
Niche ETFs track narrower sectors of the economy such as stock sectors, bond sectors, and single countries. Niche ETFs offer less diversification, and may have higher costs, but they can be a good way to fill a specific gap in your portfolio.
Exotic ETFs track unusual strategies such as commodities and currencies. They're often more expensive and generally used by experienced investors because of their higher risk.
Leveraged ETFs are managed to move up and down faster than the index they track—some may move up three times as quickly as their index over the course of the trading day. They are often volatile and investors should seek to understand them carefully prior to investing. For more information, read Leveraged and Inverse ETFs: Not Right for Everyone.
Inverse ETFs are managed to move in the opposite direction than the indexes they track; when the index goes up, they go down. They can be used to hedge market exposure or profit from market declines, and are generally only used by experienced investors due to their risky nature. For more information, read Leveraged and Inverse ETFs: Not Right for Everyone.
The SMART Approach to Evaluating Exchange Traded Products
S - An Overview of Exchange Traded Product
M - Inside ETPs: Why Index Methodology Matters
A - Asset Management Considerations for
Exchange Traded Products
R - Beyond the Expense Ratio: The Total Cost of
?T - Best Practices for Trading ETFs
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