Like a stock, ETFs are traded on a stock exchange, providing the flexibility to buy and sell throughout the trading day. Like a mutual fund, most ETFs allow you to own a variety of stocks or bonds inside one investment.
Exchange-traded funds offer the following benefits:
- Passive management – Most mutual fund managers practice active portfolio management by researching and handpicking individual investments in an effort to achieve a higher return or exhibit lower risk than a benchmark. Most ETF managers, on the other hand, simply try to match the return of a particular index, which is referred to as passive management. An index is a collection of individual securities designed to represent the return of a particular segment of the stock or bond market.
- Relatively low expenses – ETFs have an annual expense ratio to cover the management fees and other internal expenses of the fund. With passive ETFs, they generally try to mirror the return of an index rather than add value through individual security selection. These funds generally have lower management and administrative costs.
- Tax efficiency – The regular buying and selling that is part of portfolio management creates the potential for capital gains distributions and their resulting taxes over the life of an ETF investment.
We can help
All investments, including exchange-traded funds, carry a certain amount of risk. Your Edward Jones financial advisor can discuss your investment needs and select the most appropriate exchange-traded fund(s) to help meet those needs.
The expense ratio measures what percentage of a fund’s assets are used to pay for the operating and administrative expenses of that fund, which reduce an investor’s return. The expense ratio of a particular ETF may be higher or lower than the guidelines noted in the chart above. You should carefully review the prospectus for the ETFs expense ratio.
More than $100 million in assets under management (AUM): Hundreds of ETFs have been launched in the past few years, and many still have marginal assets under management. Edward Jones suggests investing in ETFs that have at least $100 million in AUM, which is the level we believe is helpful to sustain their operations.
Share price premium or discount relative to net asset value (NAV): An ETF’s price is determined primarily by the NAV of the fund’s underlying holdings, along with the supply of and demand for shares in the market. This may cause an ETF to trade at a premium or discount to its NAV. Edward Jones suggests seeking funds trading at minimal premiums or discounts to NAV. Most broad-based ETFs trade within 2% of the fund’s NAV, although this spread could widen in periods of market volatility. The premium or discount could also be more significant for more narrowly focused ETFs.
Use ETFs to build your portfolio
Broad-based ETFs can make up the core building blocks of your portfolio. If you’re interested in investing in a specific asset class, such as large- or small-cap equity, international equity or fixed income, chances are there’s an ETF for you.
You can also incorporate ETFs representing various investment styles — for example, dividend income or capital appreciation — into your portfolio.
Use ETFs with individual stocks and bonds
ETFs can provide lower-cost, broad exposure to asset classes that can help further diversify your portfolio. Do you already own several individual large-cap domestic stocks? Speak to your financial advisor about how an international or small-cap ETF may fit into your portfolio. Similarly, if you own many individual bonds, speak to your financial advisor about how a broad intermediate or short-term fixed income ETF may benefit your portfolio.
Use ETFs to complement a mutual fund portfolio
You can use ETFs with mutual funds to achieve even more diversification.
For example, an ETF could fill a gap in your portfolio of mutual funds. If you already own a number of large-cap domestic equity and international equity as well as fixed-income mutual funds, you may further diversify by adding exposure to the mid- or small-cap asset classes. If the mutual fund family doesn’t have a fund that meets your needs, you may consider adding a mid- or small-cap ETF instead.
ETFs also can provide exposure to certain asset classes with a more limited number of fund choices, such as emerging markets or international small-cap.
If you already have a well-diversified portfolio of mutual funds with different investment categories and asset classes, ETFs may not be necessary. Remember that before you supplement your portfolio with other investment types, you should speak with your FA and read the fund's prospectus documents as you may be eligible for break points — or lower fees — if you invest a certain amount with a specific mutual fund family.
An ETF’s holdings may affect capital gains or dividend distribution taxes. While most ETFs are legally structured as open-end funds, meaning there is no limit to the number of shares the fund can offer, some may not be. Certain ETFs may generate a K-1 tax form, which may be undesirable for some investors. You can find the details on fund structure and tax implications in an ETF’s prospectus. Talk to your qualified tax professional about your situation.
Understanding an ETF’s underlying holdings can help identify significant weightings to individual securities, industries, sectors or geographic locations, which may indicate the ETF is not as diverse as it seems. Knowing how the ETF is invested can lead to fewer performance surprises.
How to invest in ETF funds
Like stocks, ETFs trade on an exchange. This means you can place different types of orders and the time of day you place an order can affect the price you receive. ETF prices may be more volatile near the market’s opening and closing. Talk with your financial advisor to understand order types and their implications.
The pros and cons of investing in ETFs
ETFs offer benefits such as low costs and diversification, which can make them attractive investments. But you should consider your goals, risk tolerance and the types of investments you prefer to own when determining whether ETFs are appropriate for you.
The benefits of investing in ETFs may include:
Low costs: Most ETFs track broad market indexes, so they don’t have to pay portfolio managers to analyze and trade shares for the fund. This generally makes owning an ETF less costly than owning an actively managed mutual fund.
Diversification: Instead of holding just one investment in an individual company, ETFs invest in a diversified portfolio of individual stocks or bonds, and you buy shares in that fund, which helps even out the ups and downs in the market.
Tax efficiency: Because ETFs mirror index mutual funds, they generally trade less often and generate fewer transactions that are taxable, which means fewer expenses for investors.
The cons of investing in ETFs may include:
Extra costs: ETF shares trade on stock exchanges, so every time an ETF share is bought or sold, the fund may incur a broker’s commission. ETFs also have bid-ask spreads, in which shares are purchased at the ask price and sold at the bid price, with the spread between the prices adding to the ETF’s transaction costs. The wider the bid-ask spread, the higher the cost to trade.
Overtrading: The potential ease of trading in and out of ETFs may tempt some investors to overtrade instead of following a more appropriate long-term investment strategy.
Use caution with these ETFs
Narrowly focused ETFs: In general, Edward Jones doesn’t recommend ETFs that focus on individual industries, countries or commodities. An ETF that’s more narrowly focused is more dependent on a certain kind of company or individual country. Narrowly focused ETFs can also have large allocations to single companies. This can lead to higher volatility over time, with more downside than investors may expect. We believe most investors should focus on broad-based ETFs that can be held for the long term and offer diversification.
Leveraged and inverse ETFs: Leveraged ETFs seek to provide a return that’s a multiple (such as two or three times) of the benchmark index’s return. Inverse ETFs aim to provide a return that’s the opposite, or the inverse, of the benchmark index return. Returns for these ETFs can lead to unexpected performance results over longer periods. Therefore, we don’t believe they are suitable long-term investments.
Are ETFs right for you? Contact an Edward Jones financial advisor to learn more about our investment advice and guidance.
Commissions, trailing commissions, management fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated.
Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates, and investors can lose some or all of their principal.