Even though exchange traded funds have been around for a few decades now, many investors are still wondering about the best ways to incorporate them into their portfolios.
As their name suggests, ETFs are investment funds that trade openly on the stock exchange. Although they have become increasingly popular of late, ETFs have actually been around since the late 1970s.
ETFs are structured similarly to mutual funds in that each share that an investor purchases represents partial ownership of an underlying group of securities. So investors in both can achieve diversification through a single purchase. However, ETFs can be bought and sold on an exchange throughout the day, whereas mutual funds can be bought or redeemed from the mutual fund company only after the close of trading. Thus, ETFs combine the diversification potential of a broad portfolio with the simplicity of trading a single stock on an exchange.
The first ETF was designed to track the performance of the S&P 500. And the majority of ETFs on the market today stay true to their passive “indexing” heritage—tracking specific indexes in the attempt to “be” the market, rather than beating it.
However, in an effort to outperform the market, some managers create specific parameters, screens or weightings when selecting securities for their ETFs. For example:
• A fund manager might start with the S&P 500 Index but choose only those stocks with the highest dividend yields.
• Another manager may create a basket of securities to invest in assets not typically covered by an index—such as currencies.
These managers are, in effect, combining elements of active and passive investing by actively creating their portfolios, which are then more passively managed on a day-to-day basis.