Exchange Traded Funds (ETFs) are “baskets of stocks” that track indices (domestic and international), industries, commodities, bonds, and even currencies. They offer a low-cost, flexible and diverse way to invest in a lot of different stocks all under one umbrella or ETF.
State Street Global Advisors launched the first ETF in 1993. Today there are 1,400 ETFs from which to choose and some $1.4 trillion in assets in them as of 2012.
This inaugural ETF, the SPDR, tracked the S&P 500, an index based on the market capitalization of the 500 largest companies traded on the New York Stock Exchange. Other index ETFs include: the Nasdaq 500 (large-cap technology), Dow Jones Industrials (30 industry-diverse companies) and Russell 2000 (companies with the smallest market caps).
The Benefits of Investing in ETFs
In addition to indices, ETFs track specific industries. Because they hold anywhere from 50-500 stocks, your risk is reduced. Instead of owning a single stock, investing in ETFs allows you to own little slices of a lot of companies.
For example, consider that a technology ETF holds Microsoft, IBM, Intel, Cisco and Apple plus quite a few other large companies in the sector. Say Apple introduces a new model of the iPhone that is not well received by the public. As a result, its stock plunges 10% in one day. However, your ETF may not go down at all or very minimally because of limited exposure to Apple.
Industry-based ETFs can focus on technology, financials, healthcare, agriculture, retail etc. These are considered broad-based. Other ETFs drill down to sub-sectors. For example, a broad healthcare ETF might own stocks related to pharmaceuticals, hospitals and insurance companies.
An ETF that focuses only on the drug industry would limit its holdings to pharmaceuticals like Eli Lilly, Bristol-Myers Squibb, Johnson & Johnson, etc. This type of ETF gives you exposure to a very specific industry, which can be good or bad.
For example, say a new law passes that increases the amount of time it takes for a drug to get FDA approval. That would likely negatively affect all of the holdings. On the contrary, good news would lift each stock and the ETF’s value as well.
Traits of ETFs
- Trade like stocks
- Allow for diversification
- Low trading fees
ETFs also allow you to invest in the price of gold, silver, copper or any other precious metal without having to own the real asset.
Diversity is just one advantage to investing in ETFs. Another is that they trade like stocks, meaning you can buy and sell them throughout the day. They are also cheaper to trade than mutual funds. A typical fee to buy an ETF at a discount brokerage is $7-$10, and there are no fees to sell.
ETFs are also tax-friendly. Unlike a mutual fund, capital gains on an ETF are not realized until all the assets are sold with the entire fund.
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