Most ETFs are broadly diversified across industries. For investors with a limited amount of money to invest, ETFs can be an excellent way to achieve diversification. Another possible advantage is the ability to sell an ETF soon after buying it without paying a penalty, as opposed to mutual funds, which often assess early withdrawal penalties. While you shouldn't make an investment with the expectation of selling it soon thereafter, in these scary times, selling may be necessary.
Finally, ETFs funds can be tax-friendly, in that they tend to distribute very low capital gains compared with actively managed funds. Therefore, ETFs are particularly efficacious for your taxable brokerage accounts. They also work well in retirement accounts.
Limitations of ETFs
Despite all the compelling advantages of investing in an ETF that replicates a stock or bond index, it is not the magic solution to all of your investment needs.
For example, you must be happy to achieve average market returns, even in declining markets, because that is the best an ETF can do. ETF managers are usually prohibited from using any defensive measures, such as moving out of stocks if they expect stock prices to decline. So ETFs will not protect your investment in the event of a market downturn.
When compared with some actively managed stock funds, which periodically take defensive measures when the market turns down, ETFs tend to be more volatile.
Choosing an ETF: A Snap
Considering there are nearly 20,000 actively managed mutual funds, sorting them out can be a challenge. The choice is much easier with ETFs: It comes down to picking those that give you instant diversification by tracking the broadest indexes. The biggest, broadest, most useful benchmarks are the following:
- The Wilshire 5000 Index comprises almost all U.S. stocks traded on major exchanges. Funds based on this index are often called "total stock market" ETFs.
- The Russell 2000 Index selects the smallest 2,000 of the 3,000 largest U.S. companies commonly traded, making it a benchmark for small-company (also known as "small-capitalization" or "small-cap") stocks.
- The MSCI EAFE Index is a mouthful that stands for "Morgan Stanley Capital International Europe, Australasia, and Far East Index." This mega-index comprises 21 country indexes representing most of the developed markets overseas.
- The Barclays Aggregate Bond Index includes U.S. government, corporate, and mortgage-backed bonds. Most "total bond market" ETFs are based on this. Investors may also choose among bond ETFs based upon the average maturity of the bonds they hold— for example, short-term, intermediate-term, and long-term.