With over 1,700 exchange traded products to choose from, investors should take the time to go over some due diligence before committing to an ETF investment.
For instance, Brett Carson, director of research for Carson Institutional Alliance, points to factors that potential ETF investors should consider, including the investment objective, tax features, fee structure, product structure and performance.
To start off, investors should have a general investment objective before diving in to the markets. ETFs can provide broad market exposure to many major benchmark indices, or the investment vehicle can target specific sectors or themes. Either way, an ETF is a low-cost, well-diversified and tax-efficient tool to access the markets.
Nevertheless, people should still look into the inner workings of their ETF investments. For instance, a broad index-based ETF can cover hundreds if not thousands of component stocks, whereas a sector-specific ETF is less diversified and may come with large tilts toward a few company stocks. Consequently, one may be exposed to higher risks and volatility when investing in specific industries as opposed to more broadly defined index-based strategies. [Best Practices for Investing in ETFs]
Taxation is another feature that ETF investors should not overlook. While most index-based ETFs are taxed at apital gains rates, some funds that hold derivatives come with a Schedule K-1 tax form. Additionally, precious metals-based ETFs that hold physical bullion are taxed as collectibles. [Some ETFs Come With Different Tax Consequences]
ETFs are lauded as a cheap way to access the markets. However, the expense ratio is only one component of the overall costs to investing in ETFs. For instance, investors should also factor in brokerage fees, rebalancing costs and the bid-ask spread on each trade. [The Various Costs of Trading ETFs]
Investors can use exchange traded funds and exchange traded notes to access broad themes, but the two investment vehicles are not the same. For example, ETNs are structured as a debt security and subject to the credit worthiness of the underwriting bank. [Investing in MLP ETFs vs ETNs]
Lastly, while ETFs try to reflect the performance of their underlying markets throughout the trading day, there are times that the ETFs may exhibit discrepancies with their net asset value. Potential investors should understand how the ETF investment works and how it tries to closely track the performance of an index or sector. [How Tracking Error Can Impact ETF Performance]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.