5 things you should know about ETFs

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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.
Exchange-traded fund (ETF) management expenses tend to be fairly low, and ETFs are generally more tax efficient than mutual funds. Although ETFs have been around for more than three decades, interest in them has gone up in recent years. In fact, assets in ETFs increased more than five-fold from 2010 to more than $6 trillion by year-end 2022, 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 distinct differences that set them apart from mutual funds, particularly in terms of tax efficiency, costs and transparency about their holdings.
Consider these five 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 overperform the index. An actively managed mutual fund may give you a higher chance of under- or overperforming 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.

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

Two ways that ETF investors incur tax liabilities are:
  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
  2. Through a capital gain that the fund distributes
The second point is where an ETF and a mutual fund tend to differ, as ETFs generally distribute capital gains less frequently than do comparable mutual funds.

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

ETFs generally report their holdings daily, offering full transparency to their investments. This lets you know more about the details of your investments compared with mutual funds, which are only required to disclose their holdings quarterly. Better transparency can make you more aware of possible risks, such as overexposure to certain market sectors or companies.

4. ETFs provide convenient, immediate diversification

Holding a 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 they may be more concentrated in a smaller number of investments.

5. ETFs can fill specific niches in your 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 technology
  • Characteristics, for example, dividend-paying stocks
  • Geography, with a regional or country focus
  • Specialized investments, including precious metals and real estate
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
  • As an investor, you could build your entire portfolio by investing exclusively in a variety of ETFs
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.

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Diversification does not ensure a profit or guarantee against loss.

Merrill, its affiliates, and financial advisors do not 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 Service Center at 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.

Exchange-traded funds (ETF) investing involves risk. ETF shares are not guaranteed or insured by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Investment returns may fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

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.