Why Are Savvy Investors Flocking to ETFs?
Exchange Traded Funds (ETFs) originated in 1993 as an easy and low-cost way for individuals and investment firms to have easy access to indexes that meet specific investment objectives. For years, the advantages of these investment vehicles were largely unknown by those outside of the professional investing world. Now, the secret is out, and ETFs are gaining traction with investors as an indispensable tool to reach their retirement goals.
So What are ETF’s and Why are They So Popular?
An Exchange Traded Fund otherwise known as an ETF, is a type of security that incorporates a “basket” of securities, such as stocks, bonds, commodities, or other assets. Their function is to serve as a simple way to mirror the investments found in a broader market set. This investment, known as ‘Index Investing’, easily allows an investor to choose a diversified selection of equities that best matches their investment goals. A common index target might be the S&P 500. However, numerous options are available for select a group of investments. This means varying degrees of risk and reward potential depending on the investor’s risk tolerance and goals.
Because the ETF can serve as such a versatile asset, it’s become the darling child of professional investors. And it’s no wonder why! The way that Exchange Traded Funds are designed, they allow investors to target a specific category of investments that either has a higher or lower risk/reward index. It’s the versatility that allows the choice of a higher risk ETF that may outperform the larger market, or a lower risk ETF that is designed to protect against larger losses and market fluctuations.
Here are some of the advantages that are driving investors and investment advisors to Exchange Traded Funds:
Exchange-Traded Funds typically incur fewer capital gains tax due to how they are structured. Because of the very nature of the funds, there are fewer changes; thus a passive investment style leads to less capital gains than a more actively traded portfolio. This is in sharp contrast to mutual funds! Many mutual fund investors are shocked when they experience capital gains tax, even in a year where there’s a decline in the overall market value. This can happen due to changes within a mutual fund's holdings.
Even more valuable for controlling taxes is the mechanism for strategic tax harvesting; using losses to offset capital gains. This is a process where one ETF is sold as a loss for tax benefit, while immediately reinvesting the proceeds for a similar ETF to meet the same investment objectives. Done carefully, wash sale penalties can be avoided. Overall, you as the investor, can better manage when you pay capital gains tax.
ETFs report their securities daily, investors and investment advisors can immediately know what they are holding. Since ETF’s are bought and sold during the day when markets are open, buyers and sellers know exactly what they are buying/paying for the security. Most often ETFs will hold the very same mix of securities as the benchmark they track, although some ETFs holdings might vary to achieve specific goals.
Operating expense ratios tend to be lower for ETFs. Since Exchange Traded Funds track indexes or a specific basket of securities, the internal turnover of the securities is usually lower. So as a more passive investment, with less trading, the costs tend to be lower than more actively traded investment vehicles.
Liquidity/Flexibility of an ETF
The flexibility of an ETF allows for investors and investment advisors to easily move investments between asset classes and choose a different set of stocks, bonds, or commodities. This flexibility is an advantage when goals, risk tolerance, or market changes warrant an allocation adjustment.
Diversification and Risk Management
ETFs are excellent choices for increasing or decreasing an investment portfolio’s exposure to different market sectors, asset classes, industries, investment styles, and even commodities or currencies. Furthermore, changes can easily be made without having to select individual stocks or bonds. With thousands of ETFs available, investors have many choices beyond standard indexes, such as the S&P 500, Russell 2000, or Dow Jones. They can choose from specific industries, market niches, or even geographically chosen securities. Even better, custom ETF compositions can be built to suit specific goals within your investment strategy.
ETF’s are an extremely versatile financial tool, offering many advantages when used correctly within an investment portfolio. With such an array of ETF options available, it is crucial to implement the best-suited fund for an individual’s specific needs. Any investment tool is only as good as the overall financial plan created by a skilled financial advisor.
McBeath Financial Group’s comprehensive financial planning system begins with our client’s goals. Through our process, we often find carefully chosen ETFs are a great choice for a personalized strategy to achieve objectives.
Krista McBeath is an Investment Advisor, Chartered Financial Consultant, a Licensed Insurance Advisor, a Fiduciary, and an experienced tax advisor who specializes in financial planning, investments, and insurance.
She utilizes advanced tools for in-depth calculations that analyze tax and retirement scenarios to help their clients avoid a future tax time-bomb. Whether this means enjoying more of your hard-earned money in retirement or passing along assets to loved ones, with less tax burden, planning makes the difference.
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