A spider isn’t just a subject for science classes anymore. It’s also a type of exchange-traded fund (ETF) — an investment that combines the diversification and cost-effectiveness of index funds with the trading flexibility of stocks. If you think investing in ETFs might be a good idea, here are some issues to consider.
The ABCs of ETFs
ETFs are “baskets” of equities, shares of which are traded on an exchange. Like stocks, ETFs can be traded throughout the day at real-time prices. Like index funds, ETFs usually have low expense ratios and portfolio turnover because they aren’t “actively” managed. The managers simply choose the underlying stocks so the “basket” matches the makeup of the appropriate index. ETFs might be designed to track a broad market or a sector.
Standard & Poor’s Depositary Receipts, or Spiders (SPDRS) — which track the S&P 500, an index of 500 of the largest companies in the United States — were the first ETFs, premiering in 1993. Spiders now cover numerous sectors of the S&P 500 as well as other defined market capitalization groupings.
Other ETFs include Qubes, which mirror the largest 100 firms of the technology-driven Nasdaq Composite Index, and Diamonds, which move in step with the 30 large-cap companies that make up the Dow Jones Industrial Average. The increasing popularity of ETFs has resulted in increasing numbers and types being rolled out.
Weighing the Issues
One advantage of ETFs is their potential tax-efficiency. Unlike with mutual funds, ETFs need not be sold to satisfy investor redemptions, a move that can create taxable capital gains for mutual fund shareholders. A drawback is that their ease of trading may encourage more frequent trading, so it’s important for investors to remain focused on their long-term goals.
By drawing on benefits of both index funds and stocks, an ETF can potentially help reduce portfolio risk and increase returns. To learn more about ETFs or for help sorting out which ones may fit your portfolio best, contact your financial advisor.
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