What they are
Exchange-traded funds (ETFs) are baskets of securities that, before fees and expenses, typically seek to track the market performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Russell 2000 but may also be actively managed. They are traded like individual stocks on a stock exchange, meaning the price can change throughout the day — unlike a mutual fund, the shares of which can only be redeemed once a day at net asset value (NAV) (generally after 4:00 p.m. Eastern Time).
How they work
An ETF is a basket of securities that trades like a stock. The fund offers and issues its shares at their NAV only in aggregations of a specified number of shares known as “creation units.” Shares are then bought and sold intraday at market price. As an investor, you are purchasing shares of the overall portfolio, not the actual shares of the underlying investments or index components; however, you are entitled to the dividends or earned interest as distributed by the fund.
Because ETFs are traded on public stock exchanges and are held in brokerage accounts, they are generally easily bought, sold or transferred.
Advantages and disadvantages
Like most investments, there are advantages and disadvantages to investing in ETFs.
By owning an ETF, investors get:
- Liquidity. Because ETFs are traded like stocks on public exchanges, they can be bought or sold throughout the trading day at the prevailing market price.
- Diversification. Many ETFs can provide diversification by investing in a variety of stocks, bonds, commodities, and currencies in a single fund, and can help deter downside risk. Keep in mind that many ETFs can be specific to a sector or country and do not have to be a diversified fund.
- Potentially lower expenses. Annual expense ratios of many ETFs are generally lower than indexed or actively managed mutual funds.
- Low investment minimums. Many mutual funds have minimum investment requirements of $2,500 or more. ETFs can be purchased for as little as the price of one share plus any trading commissions.
- Tax efficiency. Because ETF shares are designed to be created and redeemed in-kind, shareholders generally do not experience capital gain distributions. This unique structure allows the fund, through in-kind transfers, to manage the portfolio in a tax-efficient manner and avoid passing large capital gains on to its shareholders. Additionally, many ETFs are passively managed and experience far less turnover within their portfolio than actively managed mutual funds.
- Transparency. Most ETFs fully disclose their underlying holdings on a daily basis, versus other investments that may only do this monthly or quarterly. This helps ETF investors know exactly what they own and allows them to assess risks and diversification within their portfolio.
- Trading costs. The costs of trading ETFs are an important consideration, especially for frequent traders. This includes brokerage commission, bid/ask spread, and premium/discount to fund NAV. Since ETFs trade on exchanges throughout the trading day, the market price includes a bid/ask spread and may differ from the actual NAV of the fund. This differs from mutual funds, which only trade at the end of the day at NAV.
- Occasionally higher fees. Some ETFs may have higher fees due to active management or investment in more expensive asset classes, such as commodities or currencies. It is important for investors to pay close attention to the fees associated with individual ETFs.
- Potential for volatility. ETFs that hold underlying baskets of volatile securities, like stocks or commodities, will experience the same level of volatility throughout the trading day. Wide price swings may occur and investors have the potential for loss of principal in these investments.
Available in the U.S. only since 1993, ETFs have grown to be the most popular type of exchange-traded product. By the end of 2018, approximately 2,285 ETFs addressed a broad array of market sectors and trading strategies, including index, stock, bond, commodity, and currency ETFs. While index ETFs are more numerous, actively managed ETFs have been available in the U.S. since 2008.
Diversify to help mitigate risk
A typical investing mistake is to concentrate a large percentage of your money into one type of investment — stocks, for example. To help mitigate risk, many investors diversify — which means they spread their investment dollars strategically among different assets and asset categories. Here are 3 ways to diversify.
How you can invest with Wells Fargo Advisors
If you’re looking to invest in ETFs, any of our Financial Advisors can help you create a manageable, adaptable plan for navigating your financial future — delivering consistent, practical advice and guidance. If you have a WellsTrade® account, you can sign on and find ETFs in the drop-down menu from the “quotes and research” tab under “Brokerage.”