Exchange Traded Funds (ETFs)

ETF Basics

• What they are: Uniquely structured investment funds that track broad-based or sector indexes, commodities and baskets of assets.
• Pros: Diversity in a single investment; trade on regulated exchange; can be traded on margin; no short-selling restrictions; low expense ratios; some brokers offer commission-free trading; tax efficient.
• Cons: Commissions can erode returns; bid-ask spread can be large; some ETFs may be subject to contango. (Wonder what that is? Learn more at Contango vs. Normal Backwardation and here); certain ETFs are taxed at a higher rate (e.g., ETFs that hold physical precious metals).
• How to invest: Full-service and online discount brokerages.
• Tip: Target-date ETFs are structured to adjust allocations based on your target retirement date. From an investor’s standpoint, they are an easy way to manage investments based on the number of years you have left until retirement. You just make one decision: Select the target-date fund that most closely matches the year you expect to retire.

ETFs offer access to nearly any asset class or sector, so investors can gain exposure to markets that have traditionally been challenging to tap, such as commodities and emerging markets. Interested in equities? There are ETFs that target stocks, stock sectors, foreign stocks and emerging market stocks. Would you prefer fixed-income? You can trade broad-based U.S. funds, municipal funds, international bonds, Treasury funds and emerging market debt – all with ETFs. Are commodities more your style? You can access broad-based funds, agriculture, industrial metals, precious metals and energy through ETFs.

Adding to the variety are inverse and leveraged products: Inverse ETFs are constructed by using various derivatives with the purpose of profiting from a decline in the value of the underlying benchmark (normally, we think of profiting from a rising market). Because this is similar to holding short positions, inverse ETFs are also called “short ETFs” and “Bear ETFs.” Leveraged ETFs, on the other hand, use derivatives and debt to magnify the potential returns (and, of course, potential losses as well) of an underlying index. There are many funds that are either 2x (double) or 3x (triple) leveraged, and some funds are inverse and leveraged at the same time. In general, it’s a good idea to steer away from leveraged ETFs unless you are very familiar with the way they work.

Tips for Picking ETFs:

• Decide which asset classes you want to invest in, being mindful of your overall diversification.
• Look for ETFs that track those asset classes.
• Compare options: Look at expense ratios (less is better), volume and assets under management (more is typically better).
• If you’ll be buying and selling frequently, look for brokers that offer commission-free trading for the ETFs you want.