ETFs: Do They Belong in Your Portfolio? — PT. I
By Justin | July 22
Exchange-traded funds (ETFs) have become increasingly popular since they were introduced in the United States in the mid-1990s. Their tax efficiencies and relatively low investing costs have attracted investors who like the idea of combining the diversification of mutual funds with the trading flexibility of stocks. 
ETFs can fill a unique role in your portfolio, but you need to understand just how they work and the differences among the dizzying variety of ETFs now available.
What is an ETF?
Like a mutual fund, an exchange-traded fund pools the money of many investors and purchases a group of securities. Like index mutual funds, most ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, both index mutual funds and exchange-traded funds attempt to replicate the performance of a specific index.
However, a mutual fund is priced once a day, when the fund’s net asset value is calculated after the market closes. If you buy after that, you will receive the next day’s closing price. By contrast, an ETF is priced throughout the day and can be bought on margin or sold short–in other words, it’s traded just as a stock is.
How ETFs Invest
Since their inception, most ETFs have invested in stocks or bonds, buying the shares represented in a particular index. For example, an ETF might track the Nasdaq 100, the S&P 500, or a bond index. Other ETFs invest in hard assets–for example, gold bullion. In such cases, a commodity or precious-metals ETF may buy futures contracts or quantities of bullion. With the rapid proliferation of ETFs in recent years, if there’s an index, there’s a good chance there’s an ETF that invests in it.
The New Wave of ETFs
New and unique indexes are being developed every day. As a result, ETFs that might seem similar–for example, two funds that invest in large-cap stocks–can actually be quite different. Many indexes define which securities are included based on their market capitalization–the number of shares outstanding times the price per share. 
However, other indexes and the ETFs that mimic them may select or weight securities within the index based on fundamental factors, such as a stock’s dividend yield.
Why is weighting important? Because it can affect the impact that individual securities have on the fund’s result. For example, an index that is weighted by market cap will be more affected by underperformance at a large-cap company than it would be by an underperforming company with a smaller market cap. That’s because the large-cap company would represent a larger share of the index. However, if the index weighted each security equally, each would have an equal impact on the index’s performance.
Pros and Cons of Exchange-Traded Funds
| Pros |
|---|
| ETFs can be traded throughout the day as price fluctuates |
| ETFs can be bought on margin, sold short, or traded using stop orders and limit orders, just as stocks can |
| ETFs do not have to hold cash or buy and sell securities to meet redemption demands by fund investors |
| Annual expenses are often lower, which can be especially important for long-term investors |
| Because ETFs typically trade securities infrequently, they have lower annual taxable distributions than a mutual fund |
| Cons |
| Dollar-cost averaging will require paying repeated commissions and will increase investing costs |
| If an ETF is organized as a unit investment trust, delays in reinvesting its dividends may hamper returns |
| An ETF doesn’t necessarily trade at its net asset value, and bid-ask spreads may be wide for thinly traded issues or in volatile markets |
More and more new indexes are being introduced, many of which cover narrow niches of the market, or use novel rules to choose securities. Many so-called rules-based ETFs are beginning to take on aspects of actively managed funds–for example, by limiting the percentage of the fund that can be devoted to a single security or industry.
But Wait…There’s More.
As indicated above, one of the reasons ETFs have gained ground with investors is because of their low annual expenses. Later this week, we’ll take a look at Part II of our ETF extravaganza and cover the advantages, trade offs, and special taxation associated with ETF investing.
