Most investors know how to answer the question "What is an ETF?" in a very basic way – but knowing all the details of what an exchange-traded fund offers can add a lot of value to your portfolio.
The simple definition of what an ETF is, according to Investopedia, is a basket of assets or a commodity that trades on a stock exchange. An ETF's price can change quite a bit on an intraday basis, depending on how much it is bought or sold each day.
But there's more to answering "what is an ETF" than that. How are ETFs traded? What makes them different from other investing vehicles? Are they better or worse than stocks, bonds, mutual funds, and other options?
Here's an in-depth look for investors to get a real grasp on exactly what ETFs are, their benefits, their weaknesses – plus a few ETFs for you to strengthen your portfolio today.
What Is An ETF: What Investors Need To Know
ETFs give investors the ability to invest with the right combination of diversification and focus to meet individual investing goals. They can choose a fund that follows:
- A major index, such as the Dow Jones, S&P 500, or Nasdaq
- Various sectors of the equities market (small caps, large caps, value, and growth)
- International ETFs that follow either a region, such as Europe or the Pacific Rim, or are country-specific, such as covering the market in the U.K., Australia, or Japan
- Industry ETFs that follow sectors like energy, technology, or biotechnology
- Market niche ETFs (some examples include real estate investment trusts and commodities such as gold)
Besides a tailored diversity and focus, there are several other advantages to using ETFs simply based on how they operate as investing tools. Here are a few:
- ETFs trade like a stocks. For instance, as an ETF's price fluctuates throughout the day, investors can react to steep price hikes or dips immediately to increase their return on an investment – or to shore up losses. In contrast, mutual funds are only priced at the close of business and cannot be traded on an intraday basis.
- ETFs cost less in fees than mutual funds, but share positive aspects such as diversification and low turnover. They have a low expense ratio.
- Exchanging ETFs allows investors to defer taxes until an investment is sold, so they are more tax-efficient compared to other investment options like mutual funds. Investors concerned with deferring taxes should choose ETFs that don't pay dividends and don't have large capital gains distributions.
Despite all the perks of ETF ownership, there are also a few disadvantages of which investors should take note…