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Using Diversification to Reap Higher Returns: ETFs

The trading world can get very complicated and tricky, and there are so many different types of instruments and stocks that you can use to build wealth. Exchange-traded funds are securities you can trade in that are already diversified. Meaning you don’t have to go through the hassle of buying each individual stock, instead you purchase a “basket” of multiple stocks.

An ETF can contain multiple different types of securities that have multiple assets like stocks, bonds and gold. Most ETFs track an index (ex. The S&P500, the top 500 companies in the US), and as a result are passively managed. This is contrasted with Mutual Funds where either the companies or holding percentages can be changed by the Fund Manager. Mutual Funds would be considered “Actively Managed”. The ETF manager does not spend much time managing the ETF and its investments because the ETF is following an index and updates itself automatically.

Why Should You Invest In An ETF?

ETFs have numerous advantages as an investment option, and perhaps the most significant advantage of parking your funds in an ETF is that you have to bear significantly lower costs than the traditional open-ended funds, trading flexibility and much more.

Lower costs

ETF operation costs are much lower because most of the client service-related expenses are passed on to the brokerage firms who hold the trades. Remember how Mutual Funds are actively managed? There are fees for that management that you will have to pay for in lower returns.

ETFs generally incur lower expenses in the area of monthly statements, notifications and transfers. They are not required to send statements and reports to their shareholders regularly, and fund sponsors only have to provide that information to their authorized participants who are often the direct owners of these creation units. In most cases, the brokerage firms are the ones that are held responsible for servicing these investors and not the ETF companies. The reduced administrative burden translates into significant cost savings.

Portfolio Diversification

If you’re looking for a way through which you can achieve rapid portfolio diversification and also portfolio exposure to specific sectors, styles and also industries. ETFs can also be a gateway for an investor to gain access to the desired segment and new ETFs being introduced bring in a constantly updated trading and investment strategy.

ETFs provide many investors with an efficient and safe way of investing in gold and other commodities. Since most ETFs track market indexes, they are considered to be safer than stock investments. ETF exposure to different kinds of risk is also nominal, and they are only majorly influenced by market risk.

Trading Flexibility

ETFs are bought and sold throughout the day when the trading markets are open. The pricing of ETF shares is also continuous during the regular exchange hours, and the trading is almost instantaneous, which helps investors move money through different asset classes.

Tax benefits

Another benefit ETFs afford is that they have a lower amount of capital gains tax as compared to open-ended funds. However, there still is a heavy tax to be paid in the case of dividends and the tax is classified into two brackets qualified and unqualified which is contingent to the holding duration of an ETF by a single investor.

Disadvantages Of ETFs

ETFs are a popular mode of investment, but they do carry their risks. General awareness of ETFs shortcomings can help protect you from being taken by surprise.

Fluctuations and risks

There are many different types of ETFs available, and all of them follow different market indexes and different trading patterns. All this makes them vulnerable to market risk. If your ETF follows the S&P 500, then it will exhibit much lower volatility compared to an ETF that follows the index of a specific sector such as the oil or the textile sector.

Therefore, you will need to research a bit about the ETF and its focus before investing. Quite similar to how you would research for a stock. The fundamentals of an ETF are also crucial if you are dealing with an international ETF, and investors will need to keep an eye out on its economic and social stability.

Trading fees can pile up if you’re not careful

The most significant advantage of ETFs is that you can trade and treat them like a stock, but every time you buy or sell a stock, you end up paying a commission. If you carry out your trades too frequently, then your trading fees might build up significantly causing a dent on your profits. But this also depends as some providers allow traders to trade ETFs without a fee.

Common Types Of ETFs

Stock ETFs

Stock ETFs are usually meant for long term growth and are usually less risky in general, and these are comprised of stocks. For example, some of the most common ETFs you will hear about will be tracking the S&P500.

Commodity ETFs

Commodity ETFs are unique in the sense that they help you bundle up multiple securities into a single investment, and it is also especially important to know what is inside a commodity ETF. Most commodity ETFs are focused on a single commodity and are often holding them in storage.

Bond ETFs

Bond ETFs are very similar to their name, and they are usually investing in fixed income securities like corporate bonds or treasuries. Bond ETFs also allow ordinary investors to gain exposure to benchmark bond indices in a passive way which also helps add market stability by adding liquidity and transparency during times of stress.

International ETFs

Foreign stocks are also widely recommended for building a diversified portfolio along with US stocks and bonds. ETFs that are investing in less developed country stocks and bonds are known as emerging markets or as frontier markets. Many investors use these ETFs as a way of diversifying the geographical and also the political risk that is inherent in their portfolios.

Sector ETFs

Sector ETFs are the kind of ETFs that track a specific sector or segment of a particular industry or a particular sector, and this is commonly identified in the fund title. These kinds of ETFs can be used to invest in an entire industry without having to look and piece the individual stocks in the sector.

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