6 things you should know about ETFs

Text size: aA aA aA
Exchange-traded funds are versatile, flexible and generally have low internal expenses, but they're not for everyone. Find out if ETFs may be right for you.
From the Merrill Edge Minute e-newsletter.

Key points

  • ETFs trade throughout the day just like stocks, whereas mutual funds can be purchased only at the end of the day
  • Some ETFs provide access to broad segments of the market, while others focus on hard-to-reach niches
  • Although management expenses for ETFs tend to be very low, you may pay a brokerage commission for every transaction
Although exchange-traded funds (ETFs) have been around for over two decades, in recent years interest in them has increased. Assets in ETFs have more than tripled since 2008, to well over $2 trillion in 2016, according to the Investment Company Institute, an investment fund trade group.
ETFs are exactly what their name suggests—funds that trade on an exchange just like stocks. As with regular mutual funds, ETFs own baskets of stocks, bonds or other holdings. Both mutual funds and ETFs can take a passive approach to investing by tracking market indexes, but ETFs offer distinctive differences that set them apart from mutual funds, particularly in terms of tax-efficiency, costs and transparency about their holdings.
Consider these six characteristics when determining whether ETFs might play a role in your portfolio.

1. ETFs tend to have low management expenses

Most ETFs have low fees and track an index with a low amount of tracking error. This low tracking error means that while an index-tracking ETF may be unlikely to significantly underperform the index, it is also unlikely to significantly over-perform the index. An actively managed mutual fund may give you a higher chance of under- or over-performing the index. Similarly, an active manager may be able to avoid investing in risky securities within an index or help navigate inefficient or thinly-traded markets. For more information, read Active vs. Passive: The case for and against index funds.

2. ETFs are more tax-efficient than typical mutual funds

There are two ways ETF investors incur tax liabilities:
  1. through a tax on a gain from the sale of an ETF, which would be no different from a gain on a mutual fund sale; and
  2. through a capital gain that the fund distributes.
Point two is where an ETF and a mutual fund tend to differ as ETFs distribute capital gains less frequently than do comparable mutual funds.

3. ETFs provide a clear, ongoing view of their holdings

ETFs report their holdings on a daily basis, thus have full transparency to their investments. This lets you know more about the details of your investments and could make you aware of possible risks, such as overexposure to certain market sectors or companies.

4. ETFs provide convenient, immediate diversification

Holding a broad variety of investments can help diversify the risk of a portfolio. Buying just one ETF can give you a stake in hundreds of stocks or bonds. An international ETF, for example, could broaden your portfolio with stock holdings from around the world, while a bond ETF might span much of the investment-grade market. Mutual funds may give you the same type of diversification, but some investors are looking for intra-day liquidity in a more tax efficient structure.

5. ETFs make it easier to gain access to very specialized investments

ETFs have made it much more convenient to own precious metals such as gold, silver, platinum and palladium.

6. ETFs can fill specialized niches in your stock portfolio

The proliferation of ETFs has brought with it specialized funds that reach all corners of the financial markets. ETFs may enable you to invest according to:
  • Market sectors such as energy or real estate
  • Characteristics, for example, dividend-paying stocks
  • Geography, with a regional or country focus
As these characteristics suggest, ETFs can play many roles in an investment portfolio.
  • Broad ETFs might serve as a core holding
  • More specialized funds may fill particular niches
  • Investors have increasingly been using ETFs to provide complete portfolio solutions
Whether you use ETFs, mutual funds or individual stocks and bonds to build your portfolio, it is crucial to begin by taking the time to evaluate your goals and risk tolerance to come up with the right target asset allocation. Then you can consider whether ETFs meet your particular needs.
Next steps
The links below may prompt you for your user ID and password.

Diversification does not ensure a profit or guarantee against loss.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

For more complete information on any exchange-traded fund or mutual fund, please request the fund's prospectus from the Merrill Edge® Service Center at 1.888.637.3343 and read it carefully. Before investing, carefully consider the investment objectives, risks, and charges and expenses of the fund. This and other information can be found in the fund's prospectus.

Investing involves risk, including possible loss of the principal value invested. Investments in foreign securities or sector funds, including technology, energy, precious metals or real estate stocks, are subject to substantial volatility due to adverse political, economic or other developments and may carry additional risk resulting from lack of industry diversification. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Funds that invest in small- or mid-capitalization companies experience a greater degree of market volatility than those of large-capitalization stocks and are riskier investments. Dividend payments are not guaranteed and the amount of a dividend payment, if any, can vary over time. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes, and the impact of adverse political or financial factors.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. Investing in lower-grade debt securities ("junk" bonds) may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher-rated categories. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT).

The content within this newsletter should not be construed as investment or tax advice.

Opinions are subject to change due to market conditions and fluctuations. Any investments or strategies presented do not take into account the investment objectives or financial needs of particular investors. It is important that you consider this information in the context of your personal risk tolerance, time horizon, liquidity needs and investment goals. Always consult with personal professionals before making any investment decisions, including a tax advisor.

ARPYNYCK-EXP041418