Exchange traded funds or ETFs seem like the darling of the investment world right now, as these Wall Street newcomers account for nearly one third of daily trading volume in the U.S.
In this installment of Investing 101, we're taking a closer look at an asset class that now consists of more than 1,400 different offerings with an estimated $1.2 trillion in total assets. While that is still only about 1/10th the size of the traditional mutual fund market, the growth and the influence cannot be overstated.
If you are thinking about adding ETFs to your portfolio, we have compiled a list of 5 things you need to know before buying.
1) What Exactly Is An ETF?
Unlike a mutual fund that only calculates what all its various investments are worth at the end of each trading day and then sells at that price, an ETF prices its holdings all day and trades whenever the stock market is open. Because of this live pricing and trading feature, the majority of ETFs tend to mimic price action of a particular index or asset.
"At its heart, an ETF is really an index-based mutual find that has the ability to trade intra-day on a stock exchange, versus a mutual fund which only trades once a day at the end of the business day," says Eric Pollackov, managing director of ETF capital markets at Charles Schwab.
Because of this link to an index of sector, Pollackov points out that most ETFs are considered to be passive or unmanaged investments since their primary goal is to simply track a particular benchmark not beat it.
2) Who Should Buy ETFs?
Technically, investing in an ETF is no more risky than buying a traditional mutual fund, depending on the type of asset your ETF tracks (see more Advanced ETFs below). With so many varieties and styles of ETFs to choose from, Pollackov goes as far as saying he thinks "they're for everybody." ETFs typically are very inexpensive to own, with some of the lowest fees in the industry, and since they usually don't have any minimum investment requirements, they are able to accommodate investors small or large.
3) What Are the Pros & Cons?
Pollackov cites "tradeability" as both a pro and con for would-be ETF investors. On the one hand, the fact that these funds trade all day long is a good thing "if you want to express your opinion on Technology (sector) at 12:30 in the afternoon, you have that ability." On the other hand, seeing the real-time effect that market gyrations can have on your investments can be unsettling and cause impulsive decisions.
Other risks tend to be more structural or logistical. "You need to know exactly what you're buying and how the index is designed," Pollackov says.
Different ETFs also use different methods of rebalancing, which is how they invest or divest funds to deal with daily inflows and outflows of money.
4) What Are Some of the Most Popular ETFs?
The S&P 500 SPDR ETF (SPY) is the largest and most heavily traded ETF in the world, with roughly $99 billion in assets. Other big players in the sector include the SPDR Gold ETF (GLD), the Vanguard MSCI Emerging Markets Index (VWO), the PowerShares Trust (QQQ), or the iShares Russell 2000 (IWM).
There are also dozens of smaller examples that are very actively traded ETFs but these tend to serve a more specific investment need.
5) What Are Some Alternative ETFs?
While stocks are a favorite investment category, there are numerous other asset classes represented in the universe of ETFs, including bond funds, commodities funds, as well as currency funds, country funds, and more.
You also need to be aware -or beware- of leveraged ETFs or inverse leveraged funds, which are designed to give investors returns that are 2 to 3 times bigger than the underlying index or benchmark as well as the opportunity to take long or short positions. As helpful as these leveraged ETFs can be, they clearly carry unique risks and trading tendencies that must be understood.