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Exploring the World of Exchange-Traded Funds

Less than two decades ago, the first exchange-traded fund (ETF) was launched in the United States. By now, there are more than 1,200 ETFs here with total assets over $1 trillion. ETFs may or may not belong in your portfolio; if you understand them, you can make an informed decision.

Standard model
The early ETFs were stock index funds (that is, they would hold shares of corporations included in stock indexes, so the ETFs would track those indexes). An S&P 500 Index ETF, for example, owns companies such as Apple and ExxonMobil in proportion to their presence in the index.

Investors can choose from a host of index mutual funds, so why choose an ETF? Generally, ETFs have lower expense ratios than index mutual funds, and lower expenses can enhance long-term performance. Due to their structure, ETFs are less likely than mutual funds to generate unexpected taxable gains for investors. Moreover, ETFs trade like individual stocks, so investors may have the flexibility to use the tactics open to stock investors: sell short, use stop loss orders, buy on margin, and trade listed options.

Beyond the norm
Over the past 20 years, different types of ETFs have evolved. Some remain so-called “index” ETFs because they track an index rather than let managers buy and sell selected stocks. However, those indexes may have been created just so investors can participate in an obscure but potentially rewarding corner of the stock market. To cite one example, the WisdomTree Emerging Markets Equity Income Index tracks an index of highyielding, dividend-paying stocks from places like Taiwan, Brazil, South Africa, and Malaysia.

Other ETFs depart from basic indexing. There are ETFs that track the price of gold, for example, and ETFs that follow commodity options strategies. Inverse ETFs go up when a particular index goes down; leveraged ETFs might move twice as much as an index or a commodity price, up or down.

Counting commissions
There is no magic to the ETF structure. Instead, it is a way to put together investments that have both risks and potential rewards. You should proceed cautiously and invest only if you are confident you know how a particular ETF is designed to perform.

In addition, keep in mind that you’ll buy and sell ETF shares from and to other investors. You don’t deal directly with the sponsoring financial firm as you do with mutual funds. You typically trade ETFs through a broker, and you’ll pay commissions on each trade.

Therefore, if you rely on a broker’s advice when you invest, you may wind up paying significant commissions on each ETF trade. You can cut costs by trading with a discount broker, but then you’ll probably have to make your own investment decisions.