What is an ETF?

Exchange Traded Funds, or ETFs, seem to be everywhere these days. They are a low-cost, tax efficient way to invest. They reduce your risk versus investing in a single stock. They can provide ready access to many asset classes, especially for the smaller investor.

In my novel Money Grab, I wrote:

Clients these days are convinced they can handle their own money, get all the information they need from the internet. They just set up an online account, throw in a few index funds or exchange traded funds, and they’re good to go.

But what exactly is an ETF? Is it a reasonable investment for you?

Think of an ETF is as a basket of stocks. The basket can represent all 500 stocks in the S&P index. It can represent a particular sector, such as technology, financials or healthcare. It can represent a commodity, such as gold or natural gas. Rather than try to decide which single technology or biotech stock you want to buy, you can buy a whole basket of them. If that sector goes up in price, your ETF will go up also. If the sector goes down, your ETF will go down. If you own a single technology stock, it can go up more or less than the technology sector. If you pick a top performer, you’d get better returns from the single stock. But if you picked a laggard, you’d get better performance from the ETF.

ETFs are similar to mutual funds, but have some important advantages:

  1. ETFs have lower fees than actively managed mutual funds.
  2. ETFs are generally more tax efficient than mutual funds because they trade less, generating lower capital gains distributions than mutual funds.
  3. ETFs can be bought and sold throughout the trading day just like stocks, so you get the price it was trading for at time of purchase. Mutual funds are only priced at the close of the market. ETFs can also be shorted, optioned or held on margin like stocks.
  4. ETFs have greater transparency, so you know exactly what’s in them. They typically display their holdings daily on their websites; mutual funds generally only report holdings quarterly.

Now that you know what ETFs are and how they compare to individual stocks and mutual funds, talk to your financial advisor to see if ETFs are right for you.

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