Exchange traded funds (ETFs) are a viable option for investing in the stock market. Many investors who prefer buying individual stocks (rather than mutual funds, for example) as their primary investment choice often need some broader market coverage.
Mutual funds can provide broader stock market coverage and also be used to drill down to specific market segments or components, such as market capitalization and so on.
ETFs offer many of the same ways to "slice and dice" the stock market using indexes to track those areas. ETFs are similar to index mutual funds, but with some important differences. Those differences are important in deciding if ETFs are right for you.
One of the most important differences between mutual funds and ETFs involve how each is bought and sold. For the most part, mutual funds sell and redeem (buy back) their own shares. You can buy and sell shares in a mutual fund in whole dollar amounts, since mutual funds offer fractional shares.
ETFs, on the other hand, are bought and sold in the stock market just like stocks are. You use a broker to place your buy or sell order and pay a commission to the broker.
You can use advanced trading techniques such as margin and limit orders when you buy or sell ETFs. This gives you the advantage of buying and selling ETFs as a short-term trading strategy.
Many mutual funds will not allow you to frequently buy and sells your shares and encourage you to be a long-term investor.
ETFs are not suitable for dollar cost averaging since you must buy in normal stock market amounts (100 shares) or pay a higher commission.
Types of ETFs
There are many different types of ETFs that cover very familiar indexes and others that cover niche markets. Here are the main types of ETFs, but this is certainly not an exhaustive list of the possibilities:
- Market Index ETFs
- Market ETFs
- Sector ETFs
- Commodity ETFs
Exchange Traded Funds cover a wide variety of indexes and markets. This section looks at the major types of ETFs and the markets they cover.
Market Index ETFs
The most popular ETFs track well-known indexes such as the S&P 500, the Nasdaq 100 Composite Index, the Dow, and other indexes. These ETFs are pure index funds and follow the movement of the index.
Index ETFs cover not only stock indexes but bond indexes as well. Bonds are sensitive to interest rates, so anticipated changes in market interest rates will affect bond ETFs.
These ETFs allow investors to diversify their holdings with a single purchase of a market index. If investors believe an index is going to rise, they will buy the corresponding ETF in anticipation of the gain. Likewise, an anticipated drop in the index may send investors a sell signal and the price of the ETF will fall.
Market ETFs
Market ETFs are typically broader in scope than most popular indexes. While it may seem like market indexes such as the S&P 500 cover "the market," in truth it does not cover mid and small cap stocks. A broad market index includes companies of different sizes and industrial sectors.
The Russell 5000 index and several total market indexes are covered by ETFs that give investors the opportunity to buy the broadest possible market coverage. This is useful as a strategy to balance more aggressive and narrowly focused holdings. Broad market indexes tend to be stable and more predictable.
Sector ETFs
Do you think tech (or any sector) stocks look like they are poised for growth or headed for a fall, but you are not sure which individual stocks are the best choices? Sector ETFs may be the answer.
Sector ETFs focus on particular industry or geographical sectors and are typically the highest risk ETFs. Sector ETFs are risky because they are not diversified and if the area of investment is troubled - remember Internet stocks in 2000 took a horrible beating in the stock market - the fund could suffer dramatic losses.
Sector funds also invest in geographic areas, such as overseas markets, which are also risky because of potential economic and political disruptions in some countries. Because of their risk, sector funds should only be a small portion of your holdings.
Commodity ETFs
Commodity ETFs let you follow a variety of commodities, such as gold or other resources, without the risk and complications of trading futures. These ETFs can provide you with access to an important asset class with a simple buy or sell order. You will want to limit your exposure to commodities to 5% or so (probably no more than 15%) of your investment portfolio.
Solution
ETFs are one additional tool investors in the stock market can use to accomplish their goals. The securities are not for every investor nor are they a complete solution by themselves, however they do offer a way to cover some key market exposures.
For more detailed information on ETFs, check out About.com's exchange traded funds site.
The Articles in This Series:
Investors in Stock Market Should Consider Exchange Traded Funds
Exchange Traded Funds Cover Many Parts of Stock and Bond Markets
