Investors who want to begin investing in exchange traded funds have so many choices, it could be difficult to begin. There are many risks involved with using ETFs, just as there are plenty of rewards.
“To put things in perspective, there are probably six or seven times as many mutual funds as exchange-traded funds. So think of ETFs like tools in a toolbox. Some ETFs are basic tools that you might use every day. A large-cap index might be equivalent to a flat-head screwdriver that you use on a regular basis,” Michael Sapir of ProShares said in a recent Washington Post interview.
A basic ETF is a basket of stocks that passively tracks an index comprised of a group of assets. This can range from commodities, stocks, bonds or even real estate investment trusts (REITs), reports Greg Williamson for The Motley Fool. An ETF will target a particular sector, asset class, or country and there are varied strategies that will influence the return. [Equal-Weight ETF Consistently Outperforming the S&P 500]
A broad-based ETF such as the SPDR S&P 500 (NYSEArca: SPY) or the Dow Jones Industrial Average ETF (NYSEArca: DIA) allow investors to capitalize on the movement of a group of large-cap U.S. companies, in one investment. This is one of the most cost effective ways to invest in U.S. mega-caps such as Exxon Mobile (NYSE: XOM) or Apple (NasdaqGS: AAPL). [Stock Index ETFs: Dow Jones Industrial Average Vs. S&P 500]
The most basic domestic large-cap strategy is generally harmless, however, the currency, commodity, sector-specific and leveraged areas can be dangerous if incorrectly used. Some of the more sophisticated or niche areas of the market should be approached with caution. In other words, just because it’s available does not mean anyone should just jump in.
The various strategies that ETFs allow can become dangerous to inexperienced investors. Since these funds are accessible to both individual and institutional investors, the need for more ETF education is pressing.
“What we see investors wanting is a realistic return while trying to reduce the volatility of ups and downs in their portfolio. Many studies have shown that it’s much more important as to what parts of the market, what slices of the economic landscape are in your portfolio than what particular companies are represented,” Sapir said. [How ETFs Have Helped the Average Investor]
Tisha Guerrero contributed to this article.
Full disclosure: Tom Lydon’s clients own SPY and AAPL.
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