Why Invest in ETFs?

• Diversification
  • You are investing into a “basket” of securities, not just one stock or company. Therefore, there is a variety of different stocks in a stock ETF, which helps with diversifying your portfolio. For example, VOO, a popular S&P 500 ETF, contains all of the stocks that make up the S&P 500 index.
• Professionally Managed
  • ETFs have professional fund managers overseeing their composition, ensuring that they match up to the benchmark index.
• Lower Cost
  • ETFs often cost less than mutual funds, a similar fund vehicle, in that they often have lower operating expense ratios (ERs).
• Tax Efficiency
  • One of the primary reasons for the tax efficiency of ETFs is their unique creation and redemption process. When investors buy or sell ETF shares, these transactions often occur in the secondary market between investors and not directly with the fund. When new shares are created or existing shares are redeemed, this is done “in-kind” with authorized participants (APs). This means that instead of selling securities to raise cash (which would trigger capital gains), the ETF exchanges securities for shares, avoiding taxable events.
• Trading Flexibility
  • The price of an ETF fluctuates throughout the day based on supply and demand, similar to individual stocks. This continuous pricing provides transparency and allows investors to know the exact price at which they are buying or selling shares. This also allows investors to react quickly to market changes and make timely investment decisions.

Why not invest in ETFs?

While this article has talked extensively about why ETFs are great to invest in, there are downsides to every investment. Here’s what you need to know before investing into your first ETF:

• Less Control Over Your Individual Investments
  • As an investor in an ETF, you are not choosing the individual assets that make up the fund. Rather, the ETF is professionally managed, where the professional may be investing into a company or sector you may not like.
• Most ETFs are Designed to Only Track the Market
  • Many ETFs are designed to track a benchmark index, meaning the fund will most likely not outperform the underlying assets in the index. Essentially, if you are an investor who is looking to take higher risks and beat the market, investing in an ETF may not be for you.
• Trading Fees
  • While ETFs are generally lower-cost investments compared to mutual funds, some have a trading fee, depending on the specific fund and brokerage platform. The fee could be upwards of $50 and is paid every time an investor buys/sells a fund. Although at face value this may not seem like much, if an investor buys small amounts of shares on a frequent basis, the costs can add up quickly.
• Low Trading Volume
  • The trading volume for many ETFs is low, resulting in a wider bid-ask spread (“bid” is the amount a buyer wants to pay and “ask” is price a seller wants to receive). As a result, liquidity is lower and investors may not receive the price they desire, whether when buying or when selling.

Types of ETFs to Invest In

There is a wide variety of ETFs to invest in. Here are some common ETF types you might want to consider.

• Equity ETFs
  • Equity ETFs track stock indexes or sectors. These ETFs provide diversification by capturing a portion of the world’s stocks, a broad sector, or a niche market.
• Fixed-Income ETFs
  • These ETFs invest in bonds and other fixed-income securities. They help reduce portfolio volatility and provide an additional income stream. Examples include total bond-market ETFs, which are suitable for investors unsure of which type of bonds to invest in.
• Commodity ETFs
  • Commodity ETFs track the price changes of specific commodities like gold or oil. They can be physically backed, futures-based, or equity-based, investing in the common shares of commodity producers. These ETFs can provide further diversification of a portfolio due to their low correlation with equities.
• Currency ETFs
  • Currency ETFs track the performance of currency pairs consisting of domestic and foreign currencies. They offer a hedge against currency volatility and can be used to speculate on currency price movements based on political and economic developments.
• Real Estate ETFs
  • Real estate investment trust (REIT) ETFs invest in real estate or real estate-related securities. They provide income through dividends, as REITs must pay out 90% of their taxable income to shareholders. These ETFs are attractive for income investors despite their increased volatility compared to bonds.
• Specialty ETFs
  • Specialty ETFs cater to specific investment strategies. Examples include:
    • Inverse ETFs: Profit when a particular index performs poorly by shorting stocks.
    • Leveraged ETFs: Aim to return multiples (e.g., 2× or 3×) of the return of the underlying investments using debt and derivatives. If the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% and same with a decrease in the index.
    • Sector and Industry ETFs: Focus on specific sectors or industries, such as technology or energy.
• Bitcoin and Cryptocurrency ETFs
  • These ETFs provide exposure to cryptocurrencies like Bitcoin. They can be spot ETFs, which hold the actual cryptocurrency, or futures-based ETFs, which use futures contracts to mimic the price movements of the cryptocurrency.
  • Examples of spot ETFs:
    • FBTC, IBIT, BITB
  • Examples of futures-based ETFs:
    • BITO, BITC, EETH
• Dividend ETFs
  • These ETFs focus on stocks that pay high dividends. They are designed to provide a steady income stream and are popular among income-focused investors.
• International ETFs
  • These ETFs invest in stocks or bonds of companies headquartered outside the United States. They provide exposure to global markets and can be region-specific or cover multiple countries.
• Thematic ETFs
  • Thematic ETFs focus on specific themes or trends, such as clean energy, technology innovation, or demographic shifts. They allow investors to target specific areas of interest or growth potential.
• ESG (Environmental, Social, and Governance) ETFs
  • ESG ETFs invest in companies that meet certain environmental, social, and governance criteria. They are designed for investors who want to align their investments with their values.
• Actively Managed ETFs
  • Unlike passive ETFs that track an index, actively managed ETFs have portfolio managers making decisions about which securities to include. These ETFs can be more expensive but offer the potential for higher returns through active management.

Resources:

• Fidelity – ETFs Tax Efficiency
• Investopedia – ETFs
• John Hancock Investments – What Makes ETFs Tax Efficient
• Schwab – Types of ETFs