For nearly three decades, investors have been turning to exchange-traded funds (ETFs) as a low-cost way to diversify their portfolios.
ETFs are a basket of investments, such as stocks, bonds and commodities, that trade on an exchange. The price of ETF shares fluctuate throughout the day on the market, which means ETFs provide intraday liquidity compared to mutual funds, which trade once a day after the market closes.
Most ETFs also have less-expensive management fees than mutual funds, and investors pay fewer broker commissions than if they had bought the same stocks individually.
While mutual fund assets still dominate the U.S. market, with more than US$18.5 trillion in assets under management, ETF assets have been steadily rising, surpassing $5.8 trillion in early 2021, according to Morningstar.
“ETFs are almost 30 years old and are recognized as efficient investment vehicles across a wide variety of asset classes,” says Forrest Murphy, ETF portfolio analyst with the Managed Portfolio Strategies division of RBC Wealth Management-U.S.
Murphy says ETFs are important because they ”democratize investing” by enabling both new and experienced investors to seek market returns through a range of assets and asset classes.
For instance, you can buy ETFs by asset class, such as stocks and bonds; by sector, such as real estate, health care or technology; or by geography, such as the United States, Asia or Europe. You can also buy them for the short term or long term.
“They're a jack-of-all-trades,” Murphy says. “Instead of buying one share of everything, you can get access to a diversified investment vehicle in a transparent manner that many investors can understand.”
ETFs can be used to fill gaps in a portfolio, such as adding bond exposure or more investments in gold or financial services. There are also a growing number of thematic ETFs on the market that cover emerging trends, such as cybersecurity or video games.
”The adage that 'there's an ETF for everything' is close to true,” Murphy says.
New to ETFs? What to look for
Investors new to ETFs should start by choosing the desired asset class exposure, says Tylar Lunke, senior manager of the Managed Portfolio Strategies division of RBC Wealth Management-U.S.
Lunke suggests investors then decide where within the market they would like to invest. The answers will often depend on what else you own in your portfolio. For instance, if you already own physical real estate assets, you may not want to buy real estate investment trust ETFs.
“Once you've determined your desired asset class, sector, region, assess the different available options,” Lunke says.
Although finding a product that offers the desired exposure is paramount, he also recommends reviewing other structural aspects such as the expense ratio, which is the amount an investment company charges investors to manage the fund. Similar to most investment products, the expense ratio for ETFs can be quite broad. However, many products are known for having very competitive pricing, which often tends to be significantly less than competing mutual funds or separately managed accounts.
ETFs should also have a relatively strong asset base, which is the total value of assets in the fund. Generally speaking, Lunke says, RBC seeks out funds with diversified asset bases above $100 million, which often means a fund is more stable and able to weather near-term flows in to and out of the fund.
The next metrics to consider before purchasing an ETF include tracking error and spread.
Tracking error is the divergence between the ETF price and the price movement of the ETF's benchmark, which is normally an index such as the S&P 500. The lower the tracking error the better, so the investor actually experiences the performance of the index they're seeking to track.
The spread, meanwhile, is the difference between the bid and ask prices. In other words, it's the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept, Lunke says. The spread tends to be lower with ETFs with larger asset bases and trading volume, and ultimately results in a lower cost of ownership.
What are the pros and cons of ETFs?
Like all investments, ETFs have pros and cons, although Murphy and Lunke believe the positives, such as the low cost, liquidity and transparency of most information being available on the provider's website, outweigh the negatives.
Lunke says many investors prefer to buy ETFs over individual stocks because they get diversified exposures and liquidity without the individual company risk. “I view them as tools to get exposures that otherwise might be difficult to own,” he says.
But, Lunke says, ETFs also have downsides. One of the cons of ETFs relative to similar investment vehicles, such as mutual funds, is the potential for a reduction in diversification as many price-weighted indexes are concentrated toward larger holdings, he says.
Additionally, another downside to ETFs, when compared to mutual funds, is that investors seeking to make small periodic investments would potentially be subject to fixed commissions on each trade, which can significantly eat into the net amount invested.
But despite those downsides, Lunke says, ETFs are good for short- and long-term investors looking for diversity at a low cost.
“To me, it's all of these individual pieces that lead to a diversified portfolio that you can trade efficiently, at a low cost and feel comfortable you're getting the market exposure you want,” he says.
Both Lunke and Murphy believe ETFs will continue to expand and become a key part of investor portfolios, particularly among Millennials, many of whom started investing through these popular vehicles.
“I think ETFs are the investment vehicle of the future,” Murphy says.