ETFs came in the 1990s and early 2000s and have only grown in popularity and number ever since. Exchange-traded funds are versatile securities that can be bought to enter a broad index market or an industry sub-sector.
ETFs are mutual funds traded all day like stocks but are more tax-efficient, transparent, and non-conventional. Exchange-traded funds mostly track an index, such as the S&P 500 and the Nasdaq 100. This makes them more passively managed investments as compared to the mutual funds that have to be actively managed to beat the market.
While investors may choose to create a mixed portfolio with mutual funds, commodities, and ETFs, exchange-traded funds make the most attractive investment, and we will be discussing why.
This article will discuss the basics of ETFs, the reason for their growing popularity, and why should you choose ETFs in your portfolio?
Benefits of Choosing ETFs in Your Portfolio
Here are some major benefits exchange-traded funds have over conventional investments such as mutual funds. These are the reasons why you should choose ETFs in your portfolio.
1. ETFs Can Be Traded Freely Like Stocks
The biggest boast of exchange-traded funds is that they can be freely traded like stocks. That is, ETFs are more liquid than mutual funds. Mutual funds can only be transacted at the end of the day when the market closes and the net asset value has been calculated.
Mutual funds with a single trading window have played a huge role in panic selling. Though it had been expected for ETFs as well, the opposite happened. The investor always has an option of waiting till the optimal time of transaction.
Exchange-traded funds with more than one trading window have a protective effect against the psychological factor in buying and selling and also provide the opportunity to leverage the optimal transaction time.
2. Expense Ratios Tend to Be Lower For ETFs Than Mutual Funds
Less painful expense ratios are another reason to choose ETFs in your portfolio.
According to Investopedia, typical expense ratios for mutual funds range from 0.50% to 2%. At the same time, ETF fees range from as low as 0.05% to at most around 1%. Costs or expense ratios for ETFs are typically lower than for purchasing and selling mutual funds.
Your fund managing company will deduct the expenses from the assets, and the net annual returns will hence be the fund’s total return minus the expense ratio.
Also, mutual funds are mostly actively managed. Operational costs are less for ETFs that link directly to the underlying index or market sector and do not require staff for active management. Mutual fund companies also have marketing costs to increase the assets under management. These costs again translate into high expense ratios for the investor.
According to Morningstar, in 2016, the average ETF expense ratio was 0.23%. The same for index mutual funds was 0.73%, while the actively managed mutual funds had an expense ratio of 1.45%. In other words, 20 to 30% of the total capital gains on mutual funds go in expenses.
3. ETFs Offer Instant Diversification
Diversification is a strategy that minimises risk by mixing a wide variety of investments in a portfolio. The idea is to expose the investment to various asset classes and yield higher longer-term returns.
With mutual funds, one has to buy hundreds or thousands of different securities such as stocks or bonds to diversify the whole portfolio. On the other hand, an exchange-traded fund (ETF) is inherently a diversified basket of securities that track an index.
Purchasing one ETF does not mean purchasing one bond or stock of just one company. It lets you invest in an entire sector or industry, like the S&P 500. ETFs hence are less volatile as they trade in the absence of company-specific risk.
4. ETFs Provide Exposure to Alternative Investment
Exchange-traded funds are not limited to conventional stocks and bonds. One of the reasons to choose ETFs in your portfolio is that these offer vast opportunities for alternative investment, such as private equity funds, art, antics, commodities, and hedge funds.
The alternative investment provides diversification of the portfolio and helps with risk management. More importantly, alternative investments such as gold, oil, and tangible assets act as effective hedges against inflation.
Besides, these do not observe the strict securities and commissions regulations as stocks and bonds do, which waives a few fees and duties and obscures the legal requirements.
5. ETFs are More Tax-efficient
Since mutual funds treat the whole pool of investment as a single account holder, taxes on capital gains have to be paid on a quarterly or yearly basis. In other words, whether the transaction occurs or not, taxes on the capital gains apply. This tax friction slows down the compounding of investment.
A huge advantage with exchange-traded funds is that you pay taxes on capital gains only when you sell or make transactions. This lets the investor compound the capital over long periods without the tax drag.
In an attempt to beat the market, active management of mutual funds leads to frequent selling and buying and associated tax consequences. On the other hand, ETFs are mostly passively managed and are supposed to track an index only. Hence, taxes and related expenses are lower for ETFs.
6. ETFs are More Transparent
An exchange-traded fund is known as the more transparent cousin of mutual funds. Mutual funds disclose their holdings quarterly or yearly. On the other hand, ETFs are required to post their holdings daily. This and the low liquidity of exchange-traded funds make them a more transparent investment option over the others and provide an unavoidable reason to choose ETFs in your portfolio.
ETF is a Flexible Investment that Can Suit Various Objectives
Exchange-traded funds combine the liquidity and transparency of individual stocks with the credibility and security of index mutual funds. ETFs offer a variety of strategic options to suit different objectives.
Buy-and-Hold: Using exchange-traded funds, an investor can make a broad portfolio covering both the equity and fixed-income markets. One can just hold as the portfolio moves with the benchmark by investing in broad market indexes.
Active Management of Long-term Funds: ETFs are more popular as passively managed funds. However, investors can also choose to actively manage their long-term holdings and sell out from a broad market to enter a short-term market and vice-versa, as per convenience.
Active Day-to-Day Trading: Exchange-traded funds do not bind you to hold for a certain period like many mutual funds do. And so, there are no penalties for selling and buying exchange-traded funds, except for some exceptional situations. ETFs provide intraday buying and selling in response to market movements, and you can easily trade day-to-day.
The Bottom Line- Why Choose ETFs in my Portfolio?
When an investor buys an ETF, he at once enters a whole sector with different companies, hence instant diversification. Less operational costs and marketing fees for exchange-traded funds than the mutual funds ultimately translate into lesser expense ratios for ETFs.
These, together with the flexibility of choices with investment handling, are reasons enough for ‘why choose ETFs in your portfolio’.
If you are interested in ETFs, check out our article called ‘What’s The Difference Between An Investment Trust And Unit Trust?‘