Demystifying ETFs

A friend who is looking to take over her own investments (after being displeased with her financial advisor) asked me what I thought was an important recent development for individual investors.  I told her that I thought that ETFs, Exchange Traded Funds, marked an important breakthrough.  ETFs generally referred to a pooled fund that holds a diversity of instruments (stocks, bonds, and/or derivatives) that can be traded like a stock.  Because they transact like a stock, the mechanism is similar to how stocks are traded in terms of minimums, commissions, and liquidity.  As indicated previously, I hold the bulk of my retirement savings in index funds and ETFs, here are the main reasons:

–Low fees — typically ETFs charge between 25-65 basis points of fees, compared to 2-3X that for most actively managed funds.  Since most ETFs track an index, they aren’t backed by huge management teams and analysts that drive up the fees.  Over time, the lower fees make a big difference in the value of investments.

–Diversification — although I would like to think of myself as an astute stock picker, in reality I would prefer to spend my time doing other things than analyzing specific companies, and pouring over 10-Ks and annual reports.  ETFs allow exposure to an broad asset class and I can spend my investment energies on trying to spot big cyclical turns, such as a shift to inflation.

–Ability to access difficult markets – the proliferation of different ETFs has really changed the investment landscape available to most individual investors.  For example, I am positive on emerging markets due to the higher rates of growth in emerging countries.  ETFs allow for regional and specific emerging country exposure and handle the challenges of currency conversion, access to restricted markets and less liquid holdings for you. Different ETFs are popping up daily including those with exposure to commodities, short-selling, real estate, and a range of other assets that were previously inaccesssible except for the very high net-worth investors.

–Efficiency in transactions — since ETFs trade like stocks, they can be bought and sold during the regular stock trading session.  You do need an account with a broker to hold these, and there will be commissions, but again, compared to the environment prior to ETFs, investing has become a lot simpler.

Knowing that ETFs are an option for investment, isn’t the same as selecting the right ETFs for your portfolio, to research ETFs further, a good source is etfconnect.com.

see other suggestions at this week’s Carnival of Personal Finance