Exchange-traded funds (ETF) are not a new concept. In fact, ETF’s have been around for 20 years. Yet, its sudden popularity has put the funds on the map as a desirable alternative to traditional mutual fund-type investments. Nasdaq recently reported that a mind-numbing $507.4 billion was poured into U.S.-listed ETF’s during the year. This represents an astounding increase of 55% over 2019. Additionally, the article reported that, in the first quarter of 2021, approximately 83 ETFs have been added to the 318 that were launched in 2020. About 60 ETFs have already surfaced in the second quarter of 2021, Investopedia reports.
ETFs enjoy several advantages over mutual funds, which account for their current popularity. An ETF is an exchange-traded fund that is similar to trading stocks, mutual funds, or bonds. As is the case with securities, ETFs can be bought and sold throughout the day. One big advantage ETFs have over stocks and other investment vehicles is lower fees. Depending on the type, ETFs have varying levels of risk. With ETFs, the fund provider owns the underlying assets. The fund manager then designs a basket and tracks its performance. From there, the manager sells the fund’s shares to the ETF investors.
ETFs Offer a Diverse Investment Opportunity
According to Bank of America’s website, ETFs come in a broad variety of types, each focusing on various investment strategies. The most popular ETF investment strategies include:
- Diversified passive equity ETFs – Focuses on specific markets like the S&P 500, the Dow Jones Industrial Average, and the MSCI Europe Australasia Far East (EAFE) indexes.
ETF Bonds never mature. That means that they don’t afford the investor the same protection in the same way that individual bonds do. There are no assurances that you’ll get your money back in the future. Rising interest rates are detrimental to the bond market. Conversely, falling fixed-rate bonds become more desirable, adding to an increase in demand due to rising bond prices.
Bond exchange-traded funds encompass baskets of diversified debt instruments that include both long and short-duration bonds. These bond ETFs also employ other products to boost returns, including interest rate swaps, convertible securities, floating rate bonds, and other alternative strategies.
- Niche passive equity ETFs – As with diversified passive funds, these niche portfolio funds are generally made up of the same stocks as those used to calculate particular reference indexes.
A big advantage to passive equity ETFs is lower expense ratios when compared to those afforded by mutual funds. Passively managed portfolios are tied to an underlying index or market sector. Mutual funds, for example, are more actively managed. Due to the fact that actively managed funds don’t commonly beat the performance of indexes, ETFs offer a better alternative to actively managed, higher-cost mutual funds.
- Active equity ETFs – Are a different kind of animal from Passive ETFs. They allow their managers to use their own judgment in selecting investments, rather than rigidly pegging to a benchmark index. Active ETFs may offer the potential to outperform a market benchmark, but may also incur greater risk and higher costs.
Actively managed funds generate higher fees, as a result of greater activity required by analysts, researchers, fund managers who actively buy, hold and sell stocks to achieve maximum returns. Any fund which is actively managed by a fund manager is an active fund. The fund manager actively makes decisions on how to invest a fund’s capital and conducts the trading of stocks.
- Fixed-income ETFs – focuses more on bonds rather than stocks. Major fixed-income ETFs tend to be actively managed, but have relatively low turnover and generally stable portfolios.
Just as with the case of mutual funds, fixed-income ETFs may provide a convenient way to diversify a bond portfolio to spread out the risk. It entails the ability to easily diversify different bond issues in a single transaction.
Which ETF Strategy is Right For You?
According to Forbes Advisor, the most exchange-traded funds are passively managed vehicles that track an underlying index. Only about 2% of the funds in the $3.9 billion ETF industry are actively managed, offering many of the advantages of mutual funds, but with the convenience of ETF investments. The Forbes article advises that buying active ETFs is a great way to include active management strategies in your investment portfolio. However, be aware that this tactic may incur higher expense ratios.
Regardless of which direction you choose in your ETF investment, it’s important to exercise your due diligence in making your selection. For more advice on the ETF landscape, contact us.