Since introduced in 1993, exchange traded funds, or ETFs, have changed the way many individuals invest in equities. In prior eras investors would gravitate towards well-known mutual fund managers like Peter Lynch at Fidelity, but today many are putting money into ETFs.
In this edition of Investing 101 Breakout explains how ETFs differ from mutual funds and how investors can tell which are right for their portfolios.
ETFs Don't Have Mutual Fund Fees
It's easy to confuse ETFs with the traditional funds. Kelly Campbell, founder and CEO of Campbell Wealth Management, explains that, while both mutual funds and ETFs are pools of invested money, ETFs aren't actively managed.
As a result of this "hands off" approach to investing your money, ETFs don't come with the often onerous fees associated with mutual funds. Back in the days of star money managers, a mutual fund could charge multiple percentage points just for the privilege of taking your money. Those days are gone.
ETFs Still Have Market Risk
Mutual funds may have fallen out of favor after the hot-shot fund managers failed to protect investor money during the volatility of the last ten years, but that doesn't necessarily make ETFs safer.
An ETF designed to move with a sector or index is going to do exactly what that means. So, for instance, when the financial sector melted down in 2008, the most popular ETF for financial stocks, the Financial Select SPDR (XLF), lost 3/4 of its value.
A well-designed ETF moves in lock-step with the group of stocks it's meant to represent for better and worse.
Beware Leveraged ETFs!
There are ETFs out there that claim to move 2 or even 3 times as much as their index. For instance, a 1% move in the S&P 500 could result in 2 or 3% drop in your ETF if you buy a levered product.
"These funds can be way more aggressive than you ever want to be or ever should be," warns Campbell. He advises investors to stick with the bigger, name brand ETFs which track established indexes or sectors.
Rules of Diversity Still Apply
The biggest thing to remember is that ETFs don't eliminate the basic rules of portfolio management. If anything, they make it far too easy for long-term investors to become short-term traders by putting all their money into a single sector.
Whether you pick your own stocks, stick with mutual funds or become one of the millions of investors using ETFs, the best way to get stable returns is through a portfolio that includes a range of sectors and assets. That's one rule of finance that no new product is going to change.