When most of us think about investing, our thoughts immediately jump to stocks. However, many of us are wary of what can happen when you get involved with stock picking. Instead, people are more likely to feel comfortable with various funds, carefully arrayed according to an asset allocation strategy that makes sense for them.
A relatively new entrant in the world of investing is the exchange traded fund (ETF). ETFs are growing in popularity, and the options for owning ETFs are widening.
What exactly is an ETF investment? (Exchange Traded Fund)
An ETF trades like a stock — but it isn’t stock. As an investor, it’s important to understand this distinction. An ETF tracks a particular collection of investments. It can track an index, commodities, currencies, bonds, stocks, or a basket of investments.
ETFs come with annual administrative fees (but they are usually quite small) because they are funds. And, because they trade like stocks on exchanges, ETFs are subject to regular brokerage fees. Many people like ETFs because they appear to offer many of the same benefits of mutual funds, but without some of the inconvenience associated with investing in mutual funds (which can’t be traded on an exchange).
An ETF is treated as a stock on an exchange. The price varies throughout the day, and you can even short an ETF if you want to. There are even ETFs that pay dividends. This makes ETF investing quite convenient. Indeed, many investors have started building entire portfolios using ETFs. And, because ETFs track many different assets, it is possible to engage in asset allocation using ETFs associated with various asset classes.
Why Some Investors Prefer ETFs to Stocks
Stocks focus on individual companies, so it can be difficult to make decisions about which stocks to purchase. And, of course, if the stock drops, you lose out. Many investors like ETFs because it’s possible to limit the kind of risk that can come with picking individual stocks.
Additionally, it’s possible to diversify with the help of ETFs. There all-market ETFs that track entire markets, or indexes, and there are also ETFs that focus on different cap sizes, or the various sectors and industries. And, it’s easy to diversify amongst asset classes, adding bond ETFs, commodity ETFs, and currency ETFs.
However, it is important to understand that there are still issues associated with ETFs. Some commodity ETFs experience contango, which represents problems due to a difference in price between near-term and longer-term futures contracts. Realize that there are ETFs that are derivative, and that can make a difference in the way that the ETFs move.
Investing in an ETF isn’t an excuse to take the “easy” way out and forgo research. You should understand the investments that the ETFs track and be aware of some of the problems that can occur. As always, before you invest in something you should know how it works, and understand it. While ETFs can offer an attractive alternative to stock picking, it’s vital that you also understand how ETFs work — and that you understand the risks.
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