Why should you invest in ETFs?

If you’ve been trading for a while, you’ve probably come across Exchange Traded funds, known as ETFs for short. They are an investment vehicle that is becoming increasingly popular with long and short term investors alike. ETFs bundle together a large group of individual assets, thus providing broad market coverage similar to a mutual fund - though ETFs have several distinct advantages. Read on to find out more about ETFs.

What are the main advantages of ETFs?

Simplicity

ETFs are quite easy financial products to use and understand, as they can be bought (or sold) at any time during a trading session, as easily as other financial assets. It is also possible to short sell ETFs, which can be great when you want to profit from any market movement, regardless of the direction.

Diversity

There is a wide choice of ETFs that give investors great options to diversify their investment portfolios. ETFs can be based on a fixed-income product, such as bonds, an index such as the S&P 500, a business sector such health, a commodity such as precious metals, a crypto-asset such as Bitcoin, etc.

Cost & Taxes

With ETFs, investors can be exposed to many securities through a single transaction, which costs less than having the same market coverage via individual investments. Compared to more traditional funds, ETF fees are also usually lower: no (or lower) entry/exit fees, better brokerage and management fees, etc. Another advantage of ETFs over traditional funds, like mutual funds, is that lower capital gains taxes are applied, as they’re only paid upon the sales of the fund.

Dividends

With stock ETFs, investors receive the full dividends on a pro-rata basis from the stock held within the ETFs. While the ETFs issuers must pay out the dividends, they have different ways they can do so. They can pay dividends in the form of a cash distribution, or as a reinvestment in the given ETFs.

Diversification

By investing in an entire market, rather than in individual shares, stock ETF investors can reduce the risks of investing in a single company, which is an essential factor in optimizing risk management and maximizing portfolio performance. The wide range of ETF varieties is also an advantage for diversifying your portfolio. To learn more diversification, check out Harry Markowitz's modern portfolio theory (MPT).

So, now you understand how using ETFs in your investment strategy can be useful for diversifying your portfolio. Instead of selecting 50 different assets, you could simply select a few ETFs - each containing several different securities. Therefore, idiosyncratic risk will be reduced.

Compared to traditional funds, ETFs offer lower operating costs, flexible trading conditions, better diversification options, as well as greater transparency and simplicity. Remember that you should always select ETFs depending on your investing goals and trading style, as well as your time horizon.

Here are the most important criteria for integrating ETFs into your portfolio:

• Look carefully at the ETF’s management fees before investing
• Do not overestimate past performance, as past performance is no guarantee of future returns and results
• Analyse the ETF’s price history to estimate its volatility and risk

Don't buy too many different ETFs, as ETFs are already well diversified

This article does not necessarily reflect the opinions of the editors or management of EconoTimes.