Investors are flocking to ETFs, here’s what you need to know

According to The ETF Industry Exposure & Financial Services TETF, exchange traded fund (ETF) assets under management have grown at an average annual rate of 19.4% over the last decade. BlackRock expects that almost half of investors will hold a position in at least one ETF in two years.

An ETF is a diversified collection of assets, similar to a mutual fund, that trades on an exchange (like a stock). The benefits of ETFs include diversity, tax efficiency and low costs. ETF buyers and sellers can trade in real time, while in contrast a mutual fund needs to be traded after the market closes and the fund’s value is calculated to account for the day’s move.

An ETF investor can buy as little as one share, unlike a mutual fund, which has minimum investment requirements.

Rich Powers, head of ETF product management from Vanguard told FOX Business, “The birth of the ETF structure came from the Securities Exchange Change in a report about the 1987 market crash. The report suggested that a single product that would allow for a basket of securities to be traded may have helped the market function better in such scenarios. Fast forward to today, many investors use ETFs to build long-term, low-cost, diversified portfolios.”

Lower risk

When it comes to investing, diversity is the key for reducing risk. Investors are told, “Don’t put your eggs in one basket,” and to pursue diversity by purchasing multiple assets. ETFs offer diversity because they are a collection of multiple assets bundled into one investment. In an ETF, if a single stock or bond in the collection is performing poorly, chances are, its performance will be buffered by other assets that are performing well.

 Taxation

A primary advantage of ETFs is their tax efficiency. Investors are taxed on capital gains earned on investments and by law funds have to pay out capital gains to shareholders. Due to their unique structure, ETFs pay out smaller capital gains, which leads to more favorable taxation. According to data from ETF.com, ETFs pay out 0.01% of their net asset value (NAV) as capital gains per year, versus mutual funds, which paid out 6.46% of their NAV in capital gains to shareholders.

The average ETF carries an expense ratio of 0.44%. This means that a fund will cost $4.40 in annual fees for every $1,000 you invest. The average traditional mutual fund costs 0.74% so it will come with $7.40 in annual fees per $1,000 invested, according to Morningstar Investment Research.

Where to start?

“For any investor stepping into a new area of investing, it’s important to start with a well-diversified core portfolio that helps mirror the unique circumstances an investor has – such as risk tolerance and time horizon,” according to Daniel Prince, head of product consulting for BlackRock’s iShares US wealth-advisory business.

“For personal investors looking to get started with ETFs, I would encourage them to start by diversifying across three key asset classes and geographies: broad US market equities, broad international markets and broad exposure to bonds,” Prince told FOX Business.

Vanguard offered a very similar recipe, recommending a U.S. focused ETF, a global focused ETF and an ETF with exposure to bonds.

BlackRock’s U.S. stock-focused ETF is the iShares Core S&P Total U.S. Stock Market ETF (ITOT). For those investors looking to add international exposure, Blackrock offers iShares Core MSCI Total International Stock ETF (IXUS), and its bond focused ETF is the iShares Core Total USD Bond Market ETF (IUSB).

For domestic exposure, Vanguard offers the Vanguard Total Stock Market ETF (VTI), for global exposure the Vanguard’s Total World Stock ETF (VT), and for bond exposure The Vanguard Total Bond ETF (BND).

BlackRock’s Prince thinks that a global ETF is a good idea because when investors focus on domestic equities they lose out on some diversification, which over the long term could have a negative impact on an investor’s portfolio. Vanguard notes in its description of its global ETF that the fund is recommended for longer-term investors who want global equity exposure and are willing to accept some volatility.

“My view is that too many investors are limiting their portfolio growth potential by only investing in domestic equities. We call that a home-country bias, and over the long-term it could have negative consequences on your portfolio. Considering this stage of the bull market in U.S. equities, it’s a great diversification option for investors looking to broaden their portfolio to over 40 countries,” stated Prince.

BlackRock’s Prince believes investors should allocate some of their investments to fixed income, such as a bond ETF, noting that depending on an investor’s risk tolerance and investment timeline, the allocation mix between equities and bonds may vary. “Younger investors should consider their long-term timeline as a reason to be more invested in equities, while older investors — baby boomers, for example — may prefer the steady income and stability of bonds and wish to increase their allocation there.”