View transcript for What is an ETF? video

There’s more to building your portfolio than buying stocks, bonds and mutual funds. Have you considered exchange-traded funds(ETFs)?

Exchanged Traded Funds, or ETFs, can be used as the building blocks of your portfolio or as a complement to other investments you own, providing further diversification. It all depends on your individual goals and circumstances.

What are ETFs?

An ETF is a basket of securities that you can buy or sell through a brokerage firm. ETFs are traded on major global stock exchanges, such as the New York Stock Exchange, meaning their prices can fluctuate throughout the trading day.

How do ETFs work?

Owning an ETF can feel similar to owning a mutual fund because an ETF holds a variety of securities wrapped up in a single investment package, and it has the same diversification and low cost of ownership compared to buying an individual security.

However, one difference between ETFs and mutual funds is, most ETFs are passively managed, not actively managed, as they are designed to mirror the performance of a particular market index. This is typically done by investing in the same securities as the index, and it means there is typically less buying and selling.

ETFs are generally more tax efficient and cost less than actively managed mutual funds, which makes them an attractive long-term investments.

What are the different ETF types?

There are many types of ETFs, each varying in terms of asset type, tax implication, and expense ratio. The most common ETF categories include:

Equity ETFs invest in various stock assets, usually tracking stocks in a particular industry or in an entire index of equities such as the Dow Jones Industrial Average (DJIA) or the S&P 500 Index. Equity ETFs may own stocks, generally selected based on company location, sector, or size.

Fixed-Income ETFs (Bond ETFs), invest in bonds, which are fixed-income securities. Most Bond ETFs focus on a specific subset of bonds, such as government bonds or corporate bonds, and are generally lower risk, which helps to reduce your portfolio’s volatility. Bond ETFs trade throughout the day on a centralized exchange, as opposed to individual bonds, which are sold by bond brokers.

Commodity ETFs invest in physical commodities such as natural resources or precious metals. Commodity ETFs give you either ownership in the fund’s physical stockpile of a commodity or give you equity in companies that produce a commodity or commodities.

Currency ETFs track a single currency or a basket of currencies and are often backed by bank deposits in a foreign currency. Having investments in non-dollar currency can provide your portfolio with even more diversification.

Broad Stock ETFs are diversified, often giving you exposure to multiple sectors (energy or real estate, for example), individual securities and — in the case of international ETFs — several countries. Broad Stock ETFs generally don’t rely too heavily on the performance of a certain type of company or a specific country.

Broad Bond ETFs invest in different areas of the fixed-income market, such as corporate and government securities, which generally makes their returns less dependent on the performance of specific sectors. Examples of Broad ETFs include government and corporate ETFs.

What to look for when selecting ETFs

Track record: Assess an ETF’s track record to evaluate whether it has met its performance objective. In general, you should review at least one year of actual performance history, as most ETFs should perform similarly to the underlying benchmark index. You should also review how the benchmark index itself has changed over time, as this can cause the ETF to perform differently.

Low expenses: Many ETFs have lower expenses because they’re passively managed. Passively managed ETFs representing a certain asset class tend to be similar, so costs can be an important difference. The following represents a general guideline for ETF expenses:

Source: Morningstar

The expense ratio measures what percentage of a fund’s assets are used to pay for the operating and administrative expenses of that fund, which reduce an investor’s return. The expense ratio of a particular ETF may be higher or lower than the guidelines noted in the chart above. You should carefully review the prospectus for the ETFs expense ratio.

More than $100 million in assets under management (AUM): Hundreds of ETFs have been launched in the past few years, and many still have marginal assets under management. Edward Jones suggests investing in ETFs that have at least $100 million in AUM, which is the level we believe is helpful to sustain their operations.

Share price premium or discount relative to net asset value (NAV): An ETF’s price is determined primarily by the NAV of the fund’s underlying holdings, along with the supply of and demand for shares in the market. This may cause an ETF to trade at a premium or discount to its NAV. Edward Jones suggests seeking funds trading at minimal premiums or discounts to NAV. Most broad-based ETFs trade within 2% of the fund’s NAV, although this spread could widen in periods of market volatility. The premium or discount could also be more significant for more narrowly focused ETFs.

Use ETFs to build your portfolio

Broad-based ETFs can make up the core building blocks of your portfolio. If you’re interested in investing in a specific asset class, such as large- or small-cap equity, international equity or fixed income, chances are there’s an ETF for you.

You can also incorporate ETFs representing various investment styles — for example, dividend income or capital appreciation — into your portfolio.

Use ETFs with individual stocks and bonds

ETFs can provide lower-cost, broad exposure to asset classes that can help further diversify your portfolio. Do you already own several individual large-cap domestic stocks? Speak to your financial advisor about how an international or small-cap ETF may fit into your portfolio. Similarly, if you own many individual bonds, speak to your financial advisor about how a broad intermediate or short-term fixed income ETF may benefit your portfolio.

Use ETFs to complement a mutual fund portfolio

You can use ETFs with mutual funds to achieve even more diversification.

For example, an ETF could fill a gap in your portfolio of mutual funds. If you already own a number of large-cap domestic equity and international equity as well as fixed-income mutual funds, you may further diversify by adding exposure to the mid- or small-cap asset classes. If the mutual fund family doesn’t have a fund that meets your needs, you may consider adding a mid- or small-cap ETF instead.

ETFs also can provide exposure to certain asset classes with a more limited number of fund choices, such as emerging markets or international small-cap.

If you already have a well-diversified portfolio of mutual funds with different investment categories and asset classes, ETFs may not be necessary. Remember that before you supplement your portfolio with other investment types, you should speak with your FA and read the fund's prospectus documents as you may be eligible for break points — or lower fees — if you invest a certain amount with a specific mutual fund family.

Additional considerations

Tax implications

An ETF’s holdings may affect capital gains or dividend distribution taxes. While most ETFs are legally structured as open-end funds, meaning there is no limit to the number of shares the fund can offer, some may not be. Certain ETFs may generate a K-1 tax form, which may be undesirable for some investors. You can find the details on fund structure and tax implications in an ETF’s prospectus. Talk to your qualified tax professional about your situation.

Underlying holdings

Understanding an ETF’s underlying holdings can help identify significant weightings to individual securities, industries, sectors or geographic locations, which may indicate the ETF is not as diverse as it seems. Knowing how the ETF is invested can lead to fewer performance surprises.

How to invest in ETF funds

Like stocks, ETFs trade on an exchange. This means you can place different types of orders and the time of day you place an order can affect the price you receive. ETF prices may be more volatile near the market’s opening and closing. Talk with your financial advisor to understand order types and their implications.

The pros and cons of investing in ETFs

ETFs offer benefits such as low costs and diversification, which can make them attractive investments. But you should consider your goals, risk tolerance and the types of investments you prefer to own when determining whether ETFs are appropriate for you.

The benefits of investing in ETFs may include:

Low costs: Most ETFs track broad market indexes, so they don’t have to pay portfolio managers to analyze and trade shares for the fund. This generally makes owning an ETF less costly than owning an actively managed mutual fund.

Diversification: Instead of holding just one investment in an individual company, ETFs invest in a diversified portfolio of individual stocks or bonds, and you buy shares in that fund, which helps even out the ups and downs in the market.

Tax efficiency: Because ETFs mirror index mutual funds, they generally trade less often and generate fewer transactions that are taxable, which means fewer expenses for investors.

The cons of investing in ETFs may include:

Extra costs: ETF shares trade on stock exchanges, so every time an ETF share is bought or sold, the fund may incur a broker’s commission. ETFs also have bid-ask spreads, in which shares are purchased at the ask price and sold at the bid price, with the spread between the prices adding to the ETF’s transaction costs. The wider the bid-ask spread, the higher the cost to trade.

Overtrading: The potential ease of trading in and out of ETFs may tempt some investors to overtrade instead of following a more appropriate long-term investment strategy.

Use caution with these ETFs

Narrowly focused ETFs: In general, Edward Jones doesn’t recommend ETFs that focus on individual industries, countries or commodities. An ETF that’s more narrowly focused is more dependent on a certain kind of company or individual country. Narrowly focused ETFs can also have large allocations to single companies. This can lead to higher volatility over time, with more downside than investors may expect. We believe most investors should focus on broad-based ETFs that can be held for the long term and offer diversification.

Leveraged and inverse ETFs: Leveraged ETFs seek to provide a return that’s a multiple (such as two or three times) of the benchmark index’s return. Inverse ETFs aim to provide a return that’s the opposite, or the inverse, of the benchmark index return. Returns for these ETFs can lead to unexpected performance results over longer periods. Therefore, we don’t believe they are suitable long-term investments.

Are ETFs right for you? Contact an Edward Jones financial advisor to learn more about our investment advice and guidance.

Important Information:

ETFs are sold by prospectus. The prospectus contains the fund’s investment objectives, risks, charges and expenses, and other important details to consider. Your financial advisor can provide a prospectus, which you should read carefully before investing.

Diversification does not guarantee a profit or protect against loss.