Understanding ETFs (And Why You Want Them in Your Portfolio)

Since bursting onto the U.S. investment scene over two decades ago, exchange-traded funds (ETFs) have become a phenomenon the likes of which Wall Street has not seen for generations.

Understanding ETFs (And Why You Want Them in Your Portfolio)

At a time when actively managed funds continue bleeding assets, ETFs keep raking in investors’ money. As of the end of July, there were nearly 4,700 exchange-traded products listed around the world which have over $3.34 trillion in combined assets under management, according to ETFGI, a London-based ETF research firm.

That is up from less than 2,500 ETFs with a combined $1.48 trillion in assets in 2010.

That growth is not showing any signs of abating. Goldman Sachs expects ETF assets to double to $6 trillion by 2020.

Not surprisingly, much of the ETF industry’s growth is being fueled by professional investors — including financial advisors — and institutional investors, including endowments, insurance companies and pension plans. However, that does not mean beginning investors cannot get involved. In fact, strong arguments can be made that beginning investors should embrace ETFs.

But before jumping in, those beginning investors should take steps toward understanding ETFs. Here are some important points to help a novice get going with this fast-growing asset class.

How ETFs Trade

When it comes to understanding ETFs, a definition frequently given to beginning investors is that “ETFs are mutual funds that trade like stocks.”

Mutual funds trade in archaic fashion, posting just one price per day: the fund’s net asset value (NAV). That means no matter what time of day an investor buys or sells shares in a mutual fund, there is only that one price.

On the other hand, ETFs transact throughout the trading day. And as with stocks, they have bid/ask spreads (the difference between the asking price and what would-be buyers are offering) and can be bought and sold with market orders, limit orders and other order types. The point regarding spreads and order terminology is important for beginning investors just getting their feet wet with ETFs.

As ETFs have grown, some have become among the most traded securities on U.S. exchanges. In fact, many ETFs experience more daily turnover than many individual stocks do. However, the ETFs that are usually among the most heavily traded are usually the 50 to 100 largest ETFs. An ETF such as the SPDR S&P 500 ETF (NYSEARCA:SPY) trades with tight spreads, which benefits investors.

Beginning investors might be tempted to buy an ETF that focuses on a narrow market segment, such as small-cap energy stocks or emerging-markets internet names, but many niche ETFs are not heavily traded.

That does not mean those are bad funds, but it does mean unknowing and beginning investors can be exposed to higher transaction costs, which can weigh on your returns.

Speaking of Costs…

Google the phrase “average ETF expense ratio” and several answers come back, but for U.S. ETFs, the average annual fee is the area of 0.43 percent to 0.45 percent. On the high side, that means the average ETF expense ratio works out to $45 per year on a $10,000 investment.

Those data points help beginning investors learn an important point about ETFs: The low fees found on many of these funds explain why so many investors have thrown in the towel on underperforming active funds. Not only do many active managers fail to consistently beat their benchmarks, but the average fee on actively managed U.S. large-cap fund is much higher per year than on the equivalent, passive ETF.

There is more good news for investors. ETF issuers are constantly battling with each other for investors’ assets, and a big part of that battle is rampant paring of fees. Some ETFs, such as the iShares S&P 1500 Index Fund (ETF) (NYSEARCA:ITOT), charge as little as 0.03% a year, or just $3 on a $10,000 investment.

Add to that, beginning investors and pros alike can realize added cost savings by trading select ETFs commission-free with Fidelity, Charles Schwab Corp (NYSE:SCHW) and TD Ameritrade Holding Corp. (NASDAQ:AMTD), among others.

Bottom line: Fees and trading costs can sap your total returns. The lower your fund’s fees and trading costs are, the better your returns will be over the long-term.

Asset Classes Available With ETFs

These days, nearly every asset class under the sun is accessible via these funds. That does not mean beginning investors should load their portfolios up with Chinese small caps, emerging markets corporate bonds or water stocks however. Part of understanding ETFs is knowing where to draw the line within the confines of your own risk tolerance.

Practical advice for a novice investor should include starting with the basics, such as broad market exposure to U.S. stocks, developed world equities and an aggregate bond fund for those who need fixed income exposure. As the investor gains a better understanding of ETFs, he or she can graduate to sector funds, emerging markets stocks and more sophisticated concepts.

Remember this advice when it comes to understanding ETFs: Issuers are not shy about bringing, let’s call them, interesting concepts to market with the hopes investors will be lured in.

That is to say, simply because an ETF exists does not mean it belongs in your portfolio. Choose wisely.

At the time of this writing, Todd Shriber did not own any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2016/09/understanding-etfs-beginning-investors/.

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