What is the big deal about ETFs?

The ETF market expanded in 2022. And in a year of not a lot in the markets that went up, this is almost unfathomable. So, why are these funds so popular? And are there downsides to them if they managed to grow in a bear market?

ETFs, or exchange-traded funds, have quickly become one of the most popular ways to invest money for both individual and professional investors. First developed in the 90’s, the ETF market has grown tremendously and is now used globally. They represent everything from broad market indices all the way to niche sectors. They are similar to a mutual fund in that most offer portfolios of several different securities. However, an ETF is bought and sold on a stock exchange instead of a mutual fund company. So, why are they all the rage?

Low Cost

 For starters, ETFs are considered to be low in cost. And since they are traded in the stock exchange, you can usually buy or sell them with zero commission. ETFs typically have lower operating expense ratios (OERs) compared to actively managed mutual funds, which typically still have a large number of commissions, fees and additional costs. Another reason for the lower cost is the passiveness of their portfolios, meaning they track indexes and/or target markets without much help from fund managers.

Diversified

Another key item that is making ETFs in high demand is the exposure to a hefty group of equities, market segments and/or styles. The diversification an ETF provides allows you to gain exposure to a variety of assets without having to select individual stocks or bonds, providing easier access to sectors in international and regional markets as well as ETFs for specific industries and market niches

Flexibility

ETFs trade like stocks, meaning you can trade them anytime during market hours, whereas traditional open-end mutual fund shares are traded only once per day after the market closes. The pricing of ETF shares is continuous during normal exchange hours, varying throughout the day. An investor will know within moments how much they paid to purchase a share and much they received after selling it. Offering versatility by allowing you to easily move money between specific asset classes, like stocks, bonds or commodities, makes same day management of a portfolio a snap. 

Transparency

A large majority of ETFs disclose their holdings on a daily basis, allowing you to know exactly what is happening, unlike the traditional open ended mutual funds who do not price their funds until the day's end, and are usually disclosed only monthly or quarterly. The more transparent an investment is to the investor, the better a decision can be made on whether to buy, sell or hold.

Tax Benefits

There are two major tax benefits when it comes to comparing ETFs to traditional mutual funds. Mutual funds usually will incur more capital gains taxes than ETFs because of the way each is structured. Capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, where mutual funds pass on capital gains taxes to investors throughout the life of the investment. When talking about taxes regarding dividends, there are 2 types of them issued by ETFs, qualified and unqualified. In order for the dividend to be qualified, it must be held by the investor for 60 days prior to the payout date. Unqualified dividends are taxed at the investors current tax rate.

Now that we know all of the great things about ETFs, let's remember that there is no such thing as the perfect investment. There are some considerations you need to make when investing in an ETF. Here are some key points to remember:

Commissions

Not all brokers charge a commission for trading an ETF, you should always check before you trade. But just like any exchange-traded security, you will typically pay one when you buy or sell an ETF. Over time, commissions can add up and become cost prohibitive, so be sure to take that into account.

Market Volatility

When you have money in the market, you always want to be prepared for market volatility. The only guarantee when it comes to the market is that it will go both up and down. Be sure to pay attention to market trends, as volatility can lead to widening of ETF bid/ask spreads. At any given time there are two prices for an ETF, the price someone is willing to buy it for, known as the bid, and the price that someone is willing to sell it for (known as the ask). When trading ETFs it is important to measure the difference between these two prices, which is called the bid-ask spread. Volatility may also affect premiums or discounts to net asset values, resulting in a higher cost for the investor. 

Some Can Be Complecated

Certain ETFs are going to present more complex based on their strategies and holdings. Before investing in any ETF, or any investment for that matter, you should carefully evaluate their features, risks, benefits and performance and compare them to your personal goals and expectations.

ETFs may feel like a great option for you, and they are for a lot of investors. To determine which ETFs are right for your portfolio, look over the common types and the strategies that are associated with them. And always turn to a professional with anything you’re unsure about!

-Sylvia McCormick Burns (Co-founder Oakview Wealth Solutions)