Every once in a while, a new form of investing will hit the marketplace and prove to be so transformative, investors are left wondering how they were ever able to live without it. Exchange-Traded Funds – commonly known as ETFs – had that impact on investment portfolios, quickly taking root and rapidly growing in popularity just after the turn-of-the-century.
An exchange-traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock. ETFs can contain all types of investments including stocks, bonds, or commodities; some offer U.S. only holdings, while others are international.
An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock. Because there are multiple assets within an ETF, they can be a popular choice for diversification. It can consist of hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector.
If you know a lot about financial markets, and buy and sell securities on your own, stock picking might not be an issue. However, if you find stock picking difficult. Rather than trying to pick individual “winners”, buying an ETF allows you to buy a whole collection of different securities and while reducing risk through diversification.
From an average investor’s perspective, ETFs can be an extremely convenient way to gain significant diversification within a portfolio while still enjoying the cost efficiencies of passive investing.
While ETFs are certainly capable of conveniently tracking broad-based indices like the S&P 500, Russell 2000, or any other popular market index, they also provide the average investor with the ability to invest in highly specialized economic sectors and asset classes. Although you can achieve the same results by buying individual stocks or – to a lesser extent – mutual funds, ETFs open the entire spectrum of the investing world to those that require convenience without substituting function.
For instance, ETFs can make it easy to integrate commodities like oil or derivatives like options, into a portfolio. If an investor wants to diversify their portfolio beyond the most common asset classes, ETFs also make it possible to purchase positions in specific economic sectors without having to spend the necessary time and resources to research individual companies.
From the typical investor’s perspective, it’s hard to find any significant drawbacks to using ETFs in your portfolio, as long as you use them in accordance with your goals, risk tolerance, and time horizon. They are convenient, cost-efficient, excel in providing heightened diversification, and easily purchased and sold since they trade on the stock markets.
Given the wide variety of ETFs available, it’s important to use those that align well with your financial goals. In other words, if you are risk-averse and most comfortable sticking with the more commonly known asset classes, an ETF that can triple short a bear market might not be appropriate for you. However, that’s where a platform that can customize an investment strategy to your risk tolerance and time horizons is essential for success.