The Inside Scoop on ETFs

ETFs…exchange-traded funds…are exactly what they sound like: funds that trade on stock exchanges. They’re like the sexier, more flexible cousins of mutual funds, and a great choice for building up wealth.

To start, every ETF holds a whole portfolio of securities – and not just American stocks, either. You can find ETFs that invest in practically everything you can think of:

  • Stocks
  • Bonds
  • Emerging markets
  • Single countries
  • Global regions
  • Market sectors
  • Commodities (like gold, gas & oil, or precious metals)
  • Leveraged shares (more exotic investments like options and futures)
  • Currencies

No matter what you want to add to your portfolio, there’s an ETF that covers it. So you get to invest in any specific area you want, without the extra risk that comes with buying single stocks (or bonds, or commodity shares). For example, if you buy stock in one company, you face all the general risks of the market PLUS risk specific to that company: it could go bankrupt, the CEO could quit, there could be an accounting scandal, a product could end up hurting people, and so much more. But when that stock is just one of hundreds in an ETF, its loss won’t hurt you nearly as much.

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In that way, ETFs act just like mutual funds – but that’s where the similarity ends. Unlike mutual funds, ETFs

  • trade on stock exchanges (mutual funds are bought directly from the mutual fund company)
  • don’t have minimum purchase requirements
  • display their holdings every day (so you know exactly what you’re buying)
  • usually have lower fees
  • create fewer taxable events (like capital gains) while you hold them

Another big difference: Since ETFs trade like stocks, you have to pay trading commissions when you buy and sell them – but that negative is more than balanced out by all the benefits of ETF investing.

Designing Your ETF Portfolio

With ETFs, you can easily create an affordable investment portfolio. In fact, with just a few strategically selected ETFs, you can build a well-diversified set of core holdings, covering virtually every corner of the market. For far less than the cost of holding individual stocks, your ETFs can give you exposure to all the major equity classes: every size of market capitalization and every market sector.

You can balance your stock holdings with a few shares of fixed-income ETFs. These add in the benefit of steady income, just like you’d get by holding individual bonds or bond funds, but with much more trading flexibility. And for an extra layer of portfolio security, you can branch out into global ETFs, which can help protect against downturns specific to the U.S. markets (investments in other countries could rally when the U.S. markets are down).

The most important thing to do before you buy even one share is research. Make sure the ETF issuer is reputable. Check to see the trading volume of the ETF – if it’s low, that could mean it will be harder to sell when you’re ready. Look at the holdings inside the ETF, and make sure they match up with the fund’s stated investment objectives (for example, you wouldn’t want to see gas and oil companies as holdings in a clean energy fund, or Wal-Mart and KFC in a tech fund). And make sure those investment objectives match yours.

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