What is an Exchange Traded Fund (ETF)?
You may have heard of an exchange traded fund, or an ETF before when trying to plan out your retirement or boost your investment portfolio. But what is an ETF and how would you benefit from one?
That’s exactly what we’re going to discuss in this article. We’re going to cover two main concepts:
- What is an ETF?
- Action items to secure your retirement
What are Exchange Traded Funds?
ETFs have grown in popularity over the past few years, with a lot of money being funneled into them for people’s retirement. We also use them in our own practice, but they should be a part of a diverse portfolio rather than the only investment that you make.
We’re going to compare an ETF to a few investment vehicles so that you have a clear understanding of ETFs and why you may want to add them to your retirement plan.
What is an ETF?
An ETF is a stock, and you can purchase it in the same way that you buy an individual stock. But the ETF itself is not a singular company. When you purchase an ETF, you’re buying into a stock of stocks.
If you wanted to purchase technology stocks, you might consider Google, Amazon, Oracle, Microsoft and plenty of others.
You would have to sit down, do your research and then purchase the stocks separately. An ETF can make this process easier by allowing you to purchase shares in the ETF, which contains a diverse set of technology stocks.
One purchase allows you to purchase a nice portfolio of stocks without needing to sit down and pick and choose stocks. It’s a lot easier to manage a single ETF than it is to manage 20 tech stocks.
If you know anything about mutual funds, you may assume that they’re the same as an ETF, but they’re not.
ETFs vs Mutual Funds
Mutual funds are one of the most common and original forms of investing outside of a single stock. A mutual fund is, at the heart of things, a company that has different investment objectives.
The objective can be:
- Mirror the S&P 500
- Mirror a sector, such as tech or healthcare
The company behind the fund will align the fund’s stocks with this objective. Within a mutual fund, there are many moving parts, including a portfolio manager and various other employees.
A mutual fund will purchase a variety of stocks and place them into their fund.
Mutual funds are a great way to invest in a more hands-off manner because you don’t have to actively manage the mutual fund. The main drawback of the mutual fund is that there are management fees, which can be high.
Since the mutual fund is a company with employees and researchers, they do have fees, which eventually eat into your investments.
ETFs are a natural move forward because they’re more cost-effective than a mutual fund.
Another major difference between an ETF and a mutual fund is that when you put in a buy or sell order for a mutual fund, the order doesn’t go through until the market closes for the day. This can be bad for your investment.
Let’s see an example.
- Overnight, a bunch of market indicators point to energy stocks dropping tomorrow.
- You put in a sell order at 9:30 in the morning to avoid losses.
- Mutual fund sell orders aren’t executed until the market closes, so you sustain losses.
You’ll find a lot of retirement accounts, such as a 401(k), relying heavily on mutual funds.
Actively Managed ETFs
A new trend is popping up where people are gravitating toward actively managed ETFs, which are very similar to mutual funds without the constraints of only being able to purchase or sell at the end of the trading day.
The downside of an actively managed ETF is that you’ll pay more fees.
If you want to manage your portfolio, you can simply sell the ETF and purchase another one if the ETF isn’t performing well. So, you have a lot of options when it comes to ETFs, and if you don’t mind paying the additional fees, you can even choose an actively managed ETF.
You can also choose the old school investment route where you purchase single stocks, add them into your account and manage everything yourself.
ETF vs Stock Purchases
If you want to build a portfolio of stocks, you can go out and purchase stocks individually. You may want to invest heavily in healthcare stocks, or perhaps you’re interested in small- and mid-sized companies.
You can go out and purchase a lot of individual stocks to properly diversify your portfolio.
But you want to manage your risks when you’re investing your retirement. If you purchase just one or two hot stocks, you can make a ton of money or lose a ton of money. Instead, purchasing a mix of stocks across sectors allows you to take on less risk in your portfolio.
Volatility is less of a concern when you have stocks in multiple sectors.
You may own hundreds of individual stocks, leading to statements that span dozens of pages. It can easily get confusing when trying to figure out which stock is a small- or medium-sized company, and then keeping up with all of these companies can be very difficult.
Researching the direction of each company and their stock is a full-time job in itself when you have a portfolio of 100 or 200 stocks.
ETFs, on the other hand, allow you to purchase 100s of stocks at once. You purchase into an ETF that has massive diversification that helps keep volatility low and reduces your own management. It’s also much easier to see an overview of your portfolio with an ETF versus hundreds of stocks.
Remember, ETFs can be bought or sold just like stock, so your buy or sell order goes through immediately.
Real World Example of ETFs in Action
Last year, in 2020, the pandemic hit, and the market was starting to fall. We chose to sell off our ETFs as the market dipped, sat on cash, and then bought back in when stimulus checks were sent out and the market started to perform better.
If you remember, Zoom and Amazon were performing very well and benefitted from the pandemic, along with other stocks.
Online and tech companies, especially large cap ETFs, were our go-to choice because these were the stocks that were performing best. When these companies started to cool towards the end of the year, we moved back to small- and mid-cap companies that began to perform very well.
You can choose a broad asset class, such as technology, or you can narrow your ETF down further with biotech ETFs.
ETFs are a great option because they allow you to purchase:
- Precious metals
- Different classes of ETFs
- Country-based ETFs
From a fee perspective, ETFs are more affordable than other options available. We’re seeing the entire investment world start to see the value of ETFs and even some 401(k) plans are moving in this direction.
If you want to learn more about what we do or how we can help you secure your retirement, you can sign up for 15-minute introductory call with us.