Diversification is your safe harbor for investments, and exchange-traded funds might be one port to drop anchor.
Looking for a way to ride out the ups and downs that may be inescapable for long-term investments? Diversification can be a safe harbor, and exchange-traded funds (ETFs) might be one of the ports that can anchor your portfolio.
ETFs, which are similar in many ways to mutual funds, have been around for 25 years, and the number of ETF choices continues to grow each year. ETFs, like mutual funds, come in many flavors and varieties, so let’s lay out some of the basics.
Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by contacting the issuing fund directly, contains this and other important information about an investment company. TD Ameritrade clients can call 800-669-3900 to obtain a prospectus. Read carefully before investing.
Like a mutual fund, an ETF is a diversified basket of securities designed to track a benchmark such as a stock index. When first devised, the funds were mostly passive, meaning your investment in the ETF would rise and fall roughly in line with the performance of the benchmark. Many still have that structure, but the ETF universe has evolved.
“An ETF can mirror an index, a commodity, bonds, or a basket of assets like an index fund,” says Patrick Smith, senior manager for trader and education marketing at TD Ameritrade.
“Unlike mutual funds, an ETF trades like a common stock on a stock exchange,” he adds. That means they can be bought and sold throughout the trading day, and prices fluctuate throughout the day. And like common stocks, many ETFs have associated options listed on exchanges. Mutual funds, in contrast, are priced and settled once a day to what’s called a net asset value (NAV).
ETFs can help investors to diversify by distributing investments across sectors, subsets of sectors, and subclasses. Some ETFs might track the S&P 500 (SPX); a specific sector, like healthcare; or a specific asset class, like small-cap stocks or international stocks. Beyond equities, there are ETFs that track commodities, and bonds, and real estate, and foreign indexes, and so forth.
As ETFs have gained in popularity over the last decade, so, too, have the variety and sophistication of the investments. Let’s name a few:
ETFs can be a low-cost way to achieve portfolio diversification, as they can avoid some of the transaction costs associated with individual stock picking or the operating costs of actively managed mutual funds. But ETF newcomers such as actively managed ETFs and smart beta ETFs generally have higher expense ratios than passive ETFs.
Fees vary across funds everywhere, whether they’re ETFs or mutual, so it’s wise to carefully read the prospectus, particularly if there are two or more ETFs tracking the same or similar indexes. And make sure the underlying securities of the ETF match what you’re looking for. TD Ameritrade offers an extensive array of commission-free ETFs.
Like mutual funds, ETFs are subject to capital gains and taxes on dividend income. But unlike mutual funds, ETFs are comprised of what are called “creation units”—large baskets of underlying securities, weighted to match the index composition. Each creation unit is broken into tiny pieces called ETF shares, which investors can buy and sell throughout the day. Because the creation units stay in the trust (unless there is a large-scale divestment, in which case a creation unit may be redeemed by the trust), there are far fewer taxable events happening within an ETF versus a mutual fund.
The tax implications on ETFs can be complicated and vary depending on the asset class and structure, but in general, an ETF investment isn’t taxed until you sell it. But remember: taxation can be dependent on how long you held an ETF.
Funds have been flooding into ETFs over the last several years, according to ETF.com, which follows the movement. 2016 saw roughly $287 billion in net creations, ETF.com says, and by the end of July, 2017 had already seen about $274 billion in net creations.
Some financial experts have expressed concerns that investors might be holding too many ETFs in their portfolios, with overlapping fund strategies that could negate some of the benefits of diversification. Also, some ETFs can be thinly traded, which means they may suffer from liquidity issues, especially during times of market stress.
As with any investment, read the prospectus, be aware of the risks, and remember that past performance is no guarantee of what might lie ahead.
Side-by-side comparison of mutual funds, ETFs and more. Log in to your account at www.tdameritrade.com > Research & Ideas > ETFs > Compare Funds
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
TD Ameritrade and all third parties mentioned are separate and unaffiliated companies, and are not responsible for each other’s policies or services.
Diversification does not eliminate the risk of experiencing investment losses.
ETFs can entail risks similar to direct stock ownership, including market, sector, or industry risks. Some ETFs may involve international risk, currency risk, commodity risk, and interest rate risk. Trading prices may not reflect the net asset value of the underlying securities. Commission fees typically apply.
Leveraged and inverse ETFs entail unique risks, including but not limited to: use of leverage, aggressive and complex investment techniques, and use of derivatives. Leveraged ETFs seek to deliver multiples of the performance of a benchmark. Inverse ETFs seek to deliver the opposite of the performance of a benchmark. Both seek results over periods as short as a single day. Results of both strategies can be affected substantially by compounding. Returns over longer periods will likely differ in amount and even direction from the target return for the same period. These products require active monitoring and management, as frequently as daily. They are not suitable for all investors.
TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2022 Charles Schwab & Co. Inc. All rights reserved.