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Exchange-Traded Funds – Start Learning the Basics

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Exchange-traded funds (ETFs) have become a very popular investment tool in recent years, but we know that investors still have questions. We’ve shared a resource from FlexShares, an ETF product provider, below to help answer some of your questions. More information from FlexShares can be found here. Other quality resources can be found by accessing Fidelity’s learning center and iShare’s educational materials.

“Exchange traded funds (ETFs) are pooled investment vehicles that invest in portfolios of securities. Most ETFs are passively managed to pursue cost-effective returns that generally correspond to the risk and return of specified indexes. Actively managed ETFs use more flexible trading strategies to pursue other targeted investment outcomes. ETFs have revolutionized the world of investing because of the special array of characteristics they offer, such as tax efficiency, diversification, trading flexibility, transparency and lower costs in comparison to other investment vehicles

How Do ETFs Compare with Mutual Funds?

Unlike mutual funds, which are purchased directly from a fund company, ETFs are traded on exchanges like individual stocks and can be bought or sold at market prices throughout the trading day, subject to commission costs for each trade. Here are some other comparisons and contrasts between ETFs and mutual funds.

Tax Efficiency

ETFs can be managed to capture the performance of portfolio holdings while reducing any capital gains that must be distributed to shareholders. For investors who hold ETF shares in taxable accounts, this means a reduced tax burden. While some mutual funds also are managed for tax efficiency, ETFs have an inherent advantage because the in-kind transactions that are generally used to redeem ETF shares are not regarded as taxable events.

Diversification

Similar to mutual funds, ETFs can provide instant exposure to a broad range of securities. Instead of taking concentrated risks by purchasing individual securities, investors can diversify by choosing an ETF. Although concentration risk can be mitigated in an ETF, some ETFs are still subject to concentration risk based on their investment focus.

How Can ETFs Be Used?

As ETF offerings expand, so do their investment applications. You can use ETFs alone or in combination to pursue a spectrum of investment strategies, including:

  • Asset Allocation – Use ETFs to fill diversification gaps or adjust exposures across asset classes within your portfolio.
  • Risk Management – Adjust your exposure by selecting ETFs designed to hedge specific risks.
  • Cash Equitization – If you have short-term cash holdings, ETFs can offer you immediate market exposure to minimize opportunity costs.
  • Tax Management and Loss Harvesting – ETF tax swap strategies can help you sell a security and take a tax loss – while simultaneously purchasing an ETF with similar characteristics – without triggering a potential wash sale. There can be tax implications, so please consult your tax advisor before implementing such strategies.
  • Core/Satellite – Use ETFs to add or overweight specific markets, sectors or asset classes to a core portfolio.

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