Every once in a while, a new form of investing will hit the marketplace and prove to be so transformative that investors are left wondering how they were ever able to live without it. Mutual funds, for example, took the investment world by storm and saw extraordinary growth throughout the 1980s by giving average investors the opportunity to use professionally managed, well-diversified instruments that never before existed.

Exchange traded funds – commonly known as ETFs – had a similar impact on investment portfolios as they quickly took root and rapidly grew in popularity just after the turn-of-the-century. Although, like their mutual fund cousins, they can lend high levels of diversification to investors, there are a handful of characteristics that separate ETFs from any other form of investment.

ETF Basics

An ETF is an investment fund that is traded on an exchange rather than redeemed like a mutual fund. They can invest in a variety of different investment classes, including stocks, bonds, commodities, or nearly anything else that can be actively traded. From an average investor’s perspective, ETFs can be an extremely convenient way to gain a significant amount of diversification within a portfolio while still enjoying the cost efficiencies of – most commonly – passive investing.

Using ETFs In Your Portfolio

While ETFs are certainly capable of conveniently tracking broad-based indices like the S&P 500, Russell 2000, or any of the other popular market indices, they truly shine for the average investor with their ability to invest in highly specialized economic sectors and asset classes. Although you can achieve the same results by buying individual stocks or – to a lesser extent – mutual funds, ETFs open the entire spectrum of the investing world to those that require convenience without substituting function.

For instance, ETFs can make it easy to integrate commodities like oil, derivatives like options, or a combination of the two through futures ETFs. For an investor that wants to diversify their portfolio beyond the common asset classes like large and small cap stocks, fixed income, and cash equivalents, ETFs make it possible to purchase large swaths of specific economic sectors without having to spend the necessary time and resources to research individual positions.

From the typical investor’s perspective, it’s hard to find any significant drawbacks to using ETFs in your portfolio as long as they are used appropriately. They are convenient, cost-efficient, excel in providing increased diversification, and readily available through any broker or investment manager.

Of course, given the wide variety of investments ETFs can be used for, make certain to use ones that align well with your financial goals. In other words, if you are risk averse and most comfortable sticking with the more commonly known asset classes, an ETF that can triple short a bear market might not be appropriate for you. That is a notion, however, that is true of all types of investing and is in no way exclusive to ETFs.

 

4/3/2019