All ETFs are equity securities, whatever investments they hold, and are listed on an exchange. This means buying and selling shares is easy. And all you need is a brokerage account through which to give your trading orders. Because ETFs are available for virtually every segment of the market — domestic and international, equity, fixed-income, and commodity — you can use these funds to allocate your assets among diversified portfolios of securities and other investment products.
ETFs and asset allocation
Simply put, asset allocation is the strategy of spreading your investment capital among different asset classes, or categories, to reduce the risk of being too narrowly focused without significantly reducing long-term return potential. While allocating can help achieve this goal, it doesn’t guarantee a profit or mean you can’t lose money.
Asset allocation can be effective because stocks, bonds, real estate, and commodities tend to behave differently from each other as market conditions fluctuate. The result is that when one asset class is providing strong returns, at least some of the others are not. However, no one class is on top all the time, and while there’s a pattern of ups and downs that affects all asset classes, its timing is never predictable.
If your goal is to be in a position to benefit from strong performers, a potential solution is to be invested across multiple asset classes at all times. ETFs can play a particularly important role in this process because they offer access to both broad and narrow segments of each asset class — though there are more stock ETFs than other varieties. As a result, ETFs can help you fill potential holes in your portfolio — in specific sectors or terms, for example — which might otherwise be difficult to do.
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Core vs. niche ETFs
When you invest in ETFs, do you focus on core holdings or niche investments? Core ETFs are linked to broad market indexes, such as those tracking large company stocks or intermediate-term corporate bonds. Niche ETFs, which are actually in the majority concentrate on narrow, sometimes untraditional, and often volatile indexes. The range of what’s available is difficult to capture with an example or two, but you can get a sense when the list includes funds tracking fertilizers, food and beverages companies, cloud computing, and wind energy.
Niche investing involves a fair amount of risk that you could lose money, in part because the funds’ underlying investments may trade less frequently than those of core ETFs and their market values may move above or below net asset value (NAV). This can affect the price if you sell. Another consideration is how involved you want to be in managing your portfolio. Niche investing typically requires regular monitoring to stay on top of changing conditions that might suggest you sell or encourage you to add shares.
High net worth investors and those who are investing for long-term goals often devote a portion of a portfolio to riskier or narrowly focused investments. Even if you lose some money in the short term, it’s not likely to change your lifestyle. And, if you have 30 or more years to accumulate the assets you need, such a setback isn’t likely to make a major difference in your plans.
CAUGHT IN A NICHE
Building a portfolio of narrow indexes — those that track subsets of subsets or on what’s hot — may put you at a greater risk than you might think. Rather than expanding portfolio diversification, this approach tends to constrict it because you’ll be concentrated in tiny slices of the total market. What’s more, since this year’s hot topic is virtually guaranteed to not be next year’s you’re likely to buy high and sell low, violating a cardinal rule of profitable investing.
However, if you’re saving for a retirement that’s fast approaching, you may find that having too much invested in volatile ETFs — or other investments — might force you to postpone leaving work or cut back on your expectations. Or, if you’re a new investor who’s not as confident as you’d like to be with making decisions, you may be unwilling to take risks. In either case, sticking to the core — ETFs linked to broad indexes of stocks with various market caps, high-rated corporate bonds, real estate, and perhaps gold — may be more appropriate for you.
Choosing an ETF
When you have decided on an approach to ETF investing, how do you choose the specific funds that best match your needs?
- Frequently the answer lies in selecting the underlying index for each ETF you’re considering. You’ll want to make sure you understand how the index is put together and what it tracks before you invest. Differences in index construction can have a major impact on performance.
- You’ll want to read the prospectus and any other product information your broker or adviser provides on specific ETFs you’re considering. It’s smart to learn about the sponsor’s ground and philosophy, how the fund operates, and the risks of investing.
- You can check independent rating services for additional information and performance history, if it exists. While past performance may not be repeated in the future, it may provide some important clues about how an ETF has been managed.
- You should consider the expense ratio and other fees. The more you pay in annual expenses, the greater the drain on your return.
Investing in ETFs For Beginners. Explained by Inna Rosputnia
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