For many decades, mutual funds were the only option for a large majority of investors. Mutual funds made sense for several reasons, including easy diversification, a wide array of asset classes, and the ability to put them in workplace 401(k)s.
Of course, mutual funds had their drawbacks. Unlike stocks, mutual funds aren’t traded on exchanges and all buying and selling happens at the end of the day. Additionally, mutual funds aren’t very tax-efficient if held outside of a retirement account due to capital gains distributions. The investment world changed in 1993 when State Street Global Advisors created the first exchange-traded fund, or ETF (which still trades today under the SPY ticker).
ETFs are baskets of stocks like mutual funds, but trade on exchanges like stocks. This gives ETFs several advantages over mutual funds such as increased liquidity and greater tax efficiency. Below, we’ll explore the five types of ETFs to help you determine which may be right for your portfolio.
Passive vs Active Funds
Like mutual funds, ETFs can be divided into two main sub-groups: active and passive.
An active fund has a stock-picking manager controlling the flow of assets into and out of the fund. The manager buys and sells based on their own personal convictions or trading style.
Passive funds don’t have a manager who picks assets, but instead track an index as closely as possible, trying to maintain equilibrium. Passive funds seek to match the gains of the underlying index and no more. Active funds are usually more expensive than passive funds and many managers fail to beat the index benchmarks.
The first ETF from State Street was a basket of stocks tracking the S&P 500 index. For an extremely low fee, SPY tracked the 500 companies in the S&P 500 on a market-cap weighted basis, meaning the most valuable firms had the largest positions in the fund.
Stock ETFs have come a long way since the initial State Street offering. Today, you can buy stock ETFs based on the following criteria:
- Sector: industrials, financials, tech, etc.
- Country: US, UK, China, Japan, Brazil, etc.
- Style: Growth, value, blend
- Size: Large-cap, mid-cap, small-cap
There’s no shortage of options when it comes to both passive and active equity ETFs. A variety of institutions have a diverse and cost-effective library of stock ETFs that could form the core of a portfolio.
Fixed income securities are also well represented in the ETF industry. Buying bond ETFs is a bit different than buying actual bonds themselves. Bond ETFs often have a high dividend yield which acts as a pseudo-coupon. Bond ETFs are nearly as volatile as other types of ETFs since they track aggregate bond indices.
Like stock ETFs, you can find bond ETFs based on region, industry, or type of debt (corporate, municipal, federal, etc). Other types of bond ETFs include credit, mortgage debt, high yield, and inflation protection.
Buying and holding physical gold or silver can be expensive and tedious. Commodities ETFs are frequently used to add exposure to precious metals, oil, or agriculture products.
Commodities ETFs require extra caution, though, since many of them use futures contracts in an attempt to track the spot price of their underlying asset. This creates a complex investment structure with unique risks that may not be grasped by novice investors. Be sure to understand how the plumbing of an ETF works before investing in it.
Real Estate Investment Trusts (REITs)
ETFs are also a way to gain exposure to real estate without pesky appraisers or uncooperative tenants. A real estate investment trust, or REIT, is a fund that owns real estate assets with cash flows. They aren’t ETFs in the traditional sense, but REITs trade on exchanges and often hold a basket of assets.
A REIT could own residential properties like apartment buildings or single-family homes, or commercial property like offices, stores, or industrial warehouses. By law, REITs must pay out 90% of their income to shareholders in the form of dividends. A combination of REITs and equity ETFs could provide both income now and investment growth in the future.
Some exchanged-traded products aren’t for the faint of heart. Exchange-traded notes, or ETNs, are leveraged products that use futures contracts to enhance returns relative to an index. But because these funds must constantly roll over futures contracts, the price often separates from the underlying index and can become wildly volatile. Inverse and leveraged ETNs aren’t recommended for most portfolios since these products are almost always losers in the long term.
Work With an Experienced Financial Advisor
If you have any questions about the five types of ETFs and which is right for your portfolio, reach out to a team member from Good Life Financial Advisors of Mount Pleasant today! We’re happy to assist you.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
Exchange Traded Funds concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly.