Exchange Traded Funds (ETFs) were first introduced to institutional investors in 1993. Since then, they have become increasingly acceptable to advisors and investors alike due to their ability to allow greater control over the trading process. construction and diversification of the portfolio at a lower cost. You should consider making them a basic component of the foundation of your personal investment portfolio.

1. Better diversification: Most people don’t have the time or the ability to follow every stock or asset class. Inevitably, this means that an individual will gravitate towards the area in which he feels most comfortable, which may result in investing in a limited number of stocks or bonds in the same business or industry sector. Think of the telecommunications engineer who works at Lucent who bought stocks like AT&T, Global Crossing, or Worldcom. Using an ETF to buy a core position in the market as a whole or in a specific sector provides instant diversification that reduces portfolio risk.

two. Improved performance: Research and experience have shown that most actively managed mutual funds generally underperform their benchmark index. With fewer tools, limited access to institutional research, and a lack of a disciplined buy/sell strategy, most individual investors fare even worse. Without having to worry about picking individual winners or losers in a sector, an investor can invest in a basket of broad-based ETFs for major holdings and can improve a portfolio’s overall performance. For example, the Consumer Staples Select Sector SPDR was down 15% through October 23, 2008, while the S&P 500 was down more than 38%.

3. More transparency: More than 60% of Americans invest through mutual funds. However, most investors don’t really know what they own. Except for a quarterly report that shows holdings at the close of business on the last day of the quarter, mutual fund investors don’t really know what’s in their portfolio. An ETF is completely transparent. An investor knows exactly what it is made up of throughout the trading day. And the price of an ETF is available throughout the day compared to a mutual fund that trades at the closing price of the previous business day.

Four. No style drift: While mutual funds claim to have a certain bias, such as large-cap vs. small-cap stocks or growth vs. value, it’s common for a portfolio manager to move away from the core strategy outlined in a prospectus in an effort to boost returns. An active fund manager may add other stocks or bonds that may increase return or reduce risk, but are not in the sector, market capitalization or style of the main portfolio. Inevitably, this can result in an investor holding multiple mutual funds with overlapping exposure to a specific company or sector.

5. Easier rebalancing: The financial media frequently extols the virtues of rebalancing a portfolio. However, this is sometimes easier said than done. Because most mutual funds contain a mix of cash and equity and may include a mix of large-cap, small-cap, or even value and growth stocks, it is difficult to get an accurate breakdown of the mix to properly rebalance the allocation of funds. target assets. Since each ETF typically represents an index of a specific asset class, industry sector, or market capitalization, it’s much easier to implement an asset allocation strategy. Let’s say you want a 50/50 portfolio between cash and the total US stock index. If the value of the S&P 500 (represented by the SPDR S&P 500 ETF ‘SPY’) falls 10%, you could move 10% cash to return to target assignment.

6. More tax efficiency: Unlike a mutual fund that has built-in capital gains created by previous trading activity, an ETF has no such gains that an investor is required to recognize income. When an ETF is purchased, it establishes the cost basis for investing in that particular trade for the investor. And given the fact that most ETFs follow a low-turnover buy-and-hold approach, many ETFs will be very tax efficient, with individual shareholders making a profit or a loss. only when in fact they sell their own ETFs.

7. Lower transaction costs: Trading an ETF is much cheaper than a mutual fund. In a mutual fund, there are shareholder service fees that are not required for an ETF. Additionally, ETFs eliminate the need for research and portfolio management because most ETFs follow a passive index approach. The ETF mirrors the benchmark index and there is no need for additional portfolio analyst expenses. This is why the average ETF has internal expenses ranging from 0.18% to 0.58%, while the average actively managed mutual fund incurs around 1.5% in annual expenses plus trading costs. .

To compare the total cost of owning an ETF to any mutual fund, the Financial Industry Regulatory Authority (FINRA) makes an ETF and fund analysis tool available on its website. The calculator automatically provides fee and expense data for all fund and ETF share classes. The calculator can be found at: http://apps.finra.org/fundanalyzer/1/fa.aspx.

8. Trading flexibility and implementation of sophisticated investment strategies: ETFs are traded like other stocks and bonds. So this means that an investor has the flexibility to use them to employ a variety of risk management and trading strategies, including hedging techniques like “stop loss” and “shorting,” options not available to “long-term” mutual funds. -only”.

Another advantage is the ability to use “inverse ETFs” which can provide some protection against a decline in the value of the market or sector. (An inverse ETF responds in the opposite way to the performance of the underlying benchmark. So if one wants to minimize the impact of a drop in the S&P 500 index, for example, then one can invest a portion of the portfolio in an “inverse” that will go up when the index value goes down).

Or an investor can tilt their portfolio to “overweight” a particular industry or sector by buying more than one index ETF for that area. By purchasing an index, an investor can position himself to take advantage of expected changes in this industry or area without the inherent risks involved in an individual stock.

Some investors marry their individual stocks or mutual funds and don’t want to sell and incur a loss and miss out on an expected rebound. Another tax-efficient option for an investor to consider is to sell the losing security while buying the ETF that represents the industry or sector of the security being sold. In this way, the investor can record the loss, take the tax deduction for it, and still be positioned in the area but with a more widely diversified index.

Investors, academics, and financial advisors sometimes question the “buy and hold” strategy. Some investors are looking for a more active management tactical approach that can be done with ETFs. Although ETFs represent passively created indices, an investor can actively trade them. There are a variety of trading strategies available to “ride the trends”. When an index moves above or below its 50-day moving average or 200-day moving average, this can be a signal to enter or exit the ETF. To minimize the trading costs that would be incurred when trading an ETF, an investor can use an ETF matching program that covers all trading costs. These deals are still generally less expensive than buying or selling multiple individual shares in a separately managed account or using an actively managed mutual fund.