The Role of ETFs in a Balanced Investment Portfolio
3 min read
ETFs offer investors a diverse array of investment options, similar to traditional mutual funds but more flexible in nature.
Some ETFs track an index and hold stocks that make up that index, while others leveraged ETFs seek to double or even triple an index’s returns.
Investors trade ETF shares on an exchange throughout the day, just like stocks.
Diversification
Investment professionals consistently stress the importance of diversification as an essential element in any portfolio. Diversification may not guarantee profits or shield from losses, but rather helps mitigate individual company or industry sector risk that might have an adverse impact on returns overall.
ETFs offer instantaneous diversification by giving access to multiple markets and sectors at an economical cost. When investing in popular ETFs like SPDR S&P 500 or iShares Russell 2000, for example, you are investing in an index-tracking basket of stocks.
Authorized participants (APs), large specialized investors who purchase stocks with weightings that correspond with an ETF’s index weightings in order to create additional ETF shares, exchange them to their ETF sponsor in exchange for new shares and this process helps maintain prices closer to net asset values (NAVs). EDHEC surveys also demonstrate investors’ satisfaction with ETF portfolio diversification: 95% of investment professionals were satisfied with equity and government bond ETFs in 2017, as compared to only 66% and 15% in 2006.
Taxes
ETFs do not incur taxes at the fund level; rather, investors will incur capital gains taxes when selling shares of an ETF – unlike mutual funds which tax their shareholders when distributing dividends to shareholders.
ETFs make it simple and affordable to diversify a portfolio with just the click of a button. Unlike stocks, ETFs represent ownership in an index portfolio rather than individual companies – eliminating single stock risk that drives market volatility.
ETFs offer investors tax relief by lowering the taxable amount of investment income, and provide access to industries and geographic areas otherwise difficult to reach with individual stocks or mutual funds. Furthermore, many ETFs enable short selling – a way of profiting from drops in market price by borrowing shares then returning them at reduced prices later – making ETFs attractive options for managing one’s tax situation and diversifying portfolio.
Expenses
ETFs trade like other stocks on exchanges throughout the day and can be purchased and sold at any time of day or night. ETFs track an index’s performance using passive management – this approach requires far less time investment compared with actively managed funds which constantly buy and sell securities to outshout their peers in an attempt to outperform. ETFs tend to have lower average costs since their operating mechanism includes an arbitrage mechanism to keep prices consistent with those underlying assets.
ETFs offer investors a flexible means to access virtually any stock market around the globe or industry sector within it, as well as exposure to bond indexes or even alternative assets like gold. Investors have reported high levels of satisfaction with ETFs – particularly traditional asset classes such as stocks and bonds.
Innovation
Many investors seek market returns when stocks surge upward, as well as peace of mind in having a balanced investment portfolio when the markets decline. Furthermore, with enough time invested over time and enough savings available for investing, more aggressively balanced portfolios can be constructed while still having enough room to recover losses during historical drawdown periods.
However, building a balanced investment portfolio may be easier and less expensive with mutual funds or ETFs that provide all of the advantages of diversification in one easy investment vehicle. Such funds typically combine stocks and bonds in an attractive combination, providing growth and income while still being tax-efficient over time. Different balanced funds have different allocations – some even keeping some assets in cash to ensure additional safety – therefore investors need to know their individual goals and risk tolerance before selecting an ideal balance fund that can meet them all.
