As retail investors, we are constantly exploring different options to earn a good return on our investments while managing the associated risks. Of the many tools and securities available for us to invest in, one is growing increasingly attractive in recent years – the Exchange Traded Fund or ETF.
Feature image courtesy of dollarsandsense.sg
What is an ETF?
Basically, an ETF is a fund that tracks a pool of securities such as stocks, bonds or commodities. Shareholders can then buy shares in the ETF – think of it as a mutual fund without the active management from an asset manager.
With the help of Vanguard ETFs, investors can gain many of the benefits found in mutual funds such as diversification. Diversification is one of the biggest draws of mutual funds. ETFs are no different, because at any one time a fund could have a few hundred or even a few thousand assets under its belt. Transparency is another factor that comes in the favor of Vanguard ETF, you as an investor can take a look at the portfolio and see the different assets which are part of the fund.
The big advantage to Vanguard ETFs however, are that they’re listed in stock exchanges and can be bought or sold like stocks on a daily basis. This flexibility brings about higher degree of liquidity than mutual funds, which helps to keep maintenance fees lower.
Why do you need ETFs in your portfolio?
Some of the major advantages of adding ETFs to your portfolio apart from diversification are as follows:
Performance Boost
Lot of times professional fund managers underperform when compared to stock markets, for individual investors it becomes even worse. With the help of vanguard ETF in your kitty, you can give your portfolio the much needed boost.
Easy Management
Adding more stocks to your portfolio from different sectors can increase the diversification. But at the same time it is very difficult to manage all of them, as the number of decisions to be made also increase dramatically. ETFs in your portfolio make it easier to manage and understand.
Tax efficient
Investing large sum of money in one or two core ETFs reduces trading activities that you would have undergone by buying and selling shares. This simply translates into lower capital gain tax as less transactions than you would pay if you were transacting on each individual asset.
Lower Fees
Similar to the tax efficient reasons above, since the numbers of trades done are fewer, the fund also incurs fewer transaction charges. Ultimately, most of these benefits are then passed on to consumers.
What should you Look Out for When Choosing ETFs?
Just like any investment tool, there are several factors that one needs to keep in mind before zeroing down on an ETF. Some of these variables are:
Low Expense Ratio
An expense ratio measures the cost to run an ETF such as management and administrative costs. Thankfully, ETFs have lower expense ratios than normal mutual funds, and in fact most of the ETFs have an expense ratio less than 1 percent.
Still, you have to be vigilant when choosing ETFs based on expense ratios. Over the course of holding the ETF, the slight differences between expense ratios can mean hundreds of dollars saved.
Sector or Class
If there is a specific sector of stocks or asset classes that you want to have in your portfolio, keep that in mind while selecting ETFs. Vanguard ETF provides you with options in various categories which we will discuss in the Types of ETFs section. Having a well-defined investment goal, as well as knowing which areas in your portfolio are lacking can help you better decide on your ETF.
Lower Commission
Here, you’re looking for opportunities for owning a cheaper portfolio. Some ETFs attract a lower commission fee than others. In fact, there are some that are completely commission free. However, there might be certain preconditions before you can enjoy commission free status. For example, you might need to hold an ETF for 30 days or more for it to be commission free.
Just because a fund is commission free doesn’t mean you don’t have to pay the expense ratios though. So be aware!
Types of ETFs
There are so many different ways to skin the cat when it comes to ETFs. We can’t go through all the types of ETFs in this article, but we can provide some broad categories under which ETFs can fall.
Equity Funds
For this category, vanguard ETF either:
- strictly follows specific indices or
- uses a sampling mechanism to replicate the index with futures and options.
There are different funds for different needs and different people. You can get your hands on small cap, mid cap or large cap funds, depending on your risk appetite and investment goals.
Bond Funds
Any investment advisor would recommend you have certain percent of your portfolio as fixed income assets such as bonds. This simply keeps volatility in check and can reduce the overall risk profile of your portfolio.
Commodity Funds
One of the primary reasons for choosing ETF is diversification of portfolios. Investing in commodities or futures themselves can be a big undertaking, especially if you’re not familiar with this less popular asset class. Thus adding a commodity vanguard ETF to your portfolio can provide you with exposure to commodities without the need for you to actively seek out and evaluate the underlying investments.
Foreign Currency
In recent years, large volatility for currencies has provided additional opportunities for investors. Couple that with the US dollar losing some of its steam, it makes sense to add foreign currency related ETFs in your portfolio. One can add foreign stocks as well. Given the high risk nature of foreign currency trading however, we’d advise that foreign currency ETFs be kept to a small portion of the portfolio.
In the End
There is a lot that one can benefit from ETFs if done with some strategy and planning. It is essential as always to keep a specific investment or financial goal and time your investments accordingly. ETFs are a great way to diversify your portfolio and with the presence of a wide category of ETFs one can balance the risk profile as well. Have you recently added ETFs to your portfolio? Tell us about it in the comments below!
