ETFs are a safer alternative, but remember, every investment has its risks! ETFs allow you to diversify your risk through products that track a basket of assets. They have low fees and high tax efficiency, which provides an advantage for long-term investors. Market ups and downs or industry-related risk factors can affect the performance of ETFs, hence it is critical to know these key components. I will explain them separately.
Diversifying Investment Risk
ETFs are a way for you to buy exposure across multiple assets and thus diversify risks over several industries or markets. This could include companies trading on a Standard & Poor’s 500 Index ETF, investing in shares from all of the big firms working throughout various sectors like information technology, healthcare, and finance. It will prevent you from having too much potential risk should one stock go down. One of the key takeaways I want you to pay attention to is that holding ETFs can dramatically lower your investment portfolio volatility. A single stock typically has an annualized volatility of 30%, while a diversified stock portfolio, whether it be equal-weighted or market-cap weighted, has around 15% volatility if measured with standard deviation.
ETFs diversify risk across broader markets as well. For example, you could purchase ETFs that specialize in emerging markets if you want stocks from developing countries, or buy commodity-specific ETFs to gain exposure to actual assets such as gold and oil. The MSCI Emerging Markets ETF returned an average of 5.6% a year for the past ten years, while over that time period, the S&P 500 Index generated gains of an annualized 9.2%. Having both ETFs will give you an overall idea of stability in returns under different market conditions.
Cost-Effectiveness
ETFs are one of the most cost-effective ways to invest. They typically have lower expense ratios: Many of the largest ETFs charge annual management fees as low as 0.1% to 0.2%, compared with actively managed mutual funds that may levy an expense ratio of around 1% or more. If you are investing $10,000 per year and earning 7% annually, after 30 years, the ETF is going to turn into about $940,000, while a mutual fund with a manager would be worth only around $760,000!
ETFs are also tax-efficient. Because of their unique structure, ETFs often only incur capital gains tax when you sell the ETF (not every year). Given an annual investment of $10,000 and a 7% rate-of-return with a 15% tax rate, it will produce approximately $940,000 in return through the ETF over thirty years, while a mutual fund would produce roughly $810,000 due to mandatory taxes on yearly gains you received as income. ETFs benefit massively in this department.
Liquidity
Because of the liquidity in these ETFs, you can buy and sell them easily during trading days. For example, the S&P 500 Index ETF (SPY), which trades more than 50 million shares a day, can be purchased or sold near market prices throughout daily trading. This high liquidity is important for the ETF to have a stable price and low trading costs per commission (as little as just a few dollars per trade).
Real-Time Pricing: ETFs have another benefit when it comes to liquidity, which is real-time pricing. They are listed on exchanges, meaning you can see their price in real-time and get it at any time. For example, I use the Nasdaq-100 Index ETF (QQQ) to get more price fluctuation data in tranches per day – another money-making opportunity with swing trading. The ability to trade in real-time and see the prices of ETFs transparently makes them more liquid and attractive than mutual funds.
Flexibility
This versatility of ETFs makes them interesting for many types of investment strategies. Hedge, Short, and Margin Trading: You can hedge or short the market with leverage via ETFs. For example, if the market goes down, you can short sell ETFs to generate income, or when it goes up, use margin trading to borrow money and amplify your returns. Leveraged ETFs also make it possible to magnify long-term results with multiples, like the 3x ProShares UltraPro QQQ ETF (TQQQ). However, this also increases the risk of significant losses.
ETFs also enable you to access various markets and asset classes with ease. International market ETFs allow you to spread investments globally, such as the Vanguard FTSE Emerging Markets ETF (VWO), which offers a wide range of emerging market stocks. Commodity ETFs use their funds to buy physical assets such as gold rather than financial securities—examples include SPDR Gold Shares (GLD). The intelligent investor should diversify investments in this way to improve the profitability and defensiveness of their portfolio.
Transparency
ETFs are popular with investors because they offer transparency. You can see exactly what an ETF owns because they must declare their holdings daily. SPDR Dow Jones Industrial ETF (DIA) and SPDR S&P 500 ETF (SPY), for instance, have daily holdings disclosure, and you can check the specific stocks and their weights at any time.
This transparency in ETFs is also reflected by the indices that they follow and their fee structures. Most ETFs try to follow specific indices, so you should be able to know what the expected returns are. The iShares Core S&P 500 ETF (IVV), for example, has a minuscule annual management fee of just 0.03%, which it openly states on its website and prospectus. This clarity enables you to know your expenses and compare them with other investment products, allowing for better-informed decision-making.
Market Risk
Even though ETFs come with many benefits, they are not entirely protected from market risks. An ETF’s performance is tied to the indices or assets they mirror, and macrofluctuations in markets will have a direct bearing on its prices. For instance, the S&P 500 Index may see a sharp decline during an economic recession, resulting in severe losses for many ETFs that track the index (like SPY). Data shows that during the 2008 financial crisis, the S&P 500 Index fell by about 37%.
Moreover, some types of ETFs are riskier than others. Financial derivatives are employed by leveraged and inverse ETFs in addition to borrowing strategies, which compound the effect of market volatility, resulting in greater volatility compared to regular ETFs. For instance, ProShares UltraPro QQQ ETF (TQQQ) aims to generate three times the daily return of the Nasdaq-100 Index and has incredibly high price volatility during periods of intense market fluctuations. TQQQ dropped around 20% in one day during a peak of market volatility in February 2018.
Sector-based or niche ETFs bring even more risk with them. While industry ETFs, like those in the energy or technology sectors, can provide returns that are much higher than broad market-based indices such as S&P 500 trackers, they tend to have significant concentrated exposure. One example is the Energy Select Sector SPDR Fund (XLE), which sees large price changes during significant oil moves. During the oil price collapse in 2014, XLE fell by around 20%. Hence, it is important to scrutinize market risks closely when selecting ETFs to ensure they complement your risk tolerance and investment goals.