Can you name an investment that acts like a stock but looks like a mutual fund?1 If you said “exchange-traded funds” (ETFs), you’re right on the money. ETFs typically consist of a “basket” of securities that mirrors a particular market index. Like stocks, ETFs trade on an exchange and can be bought or sold throughout the trading day.
Since most ETFs are designed to follow an index, fund managers generally make changes to their investment lineup only when the underlying index changes. Because the goal is to match the performance of the index, fund expenses tend to be low.You don’t need a lot of money to invest in ETFs. You can start with a small investment and increase the amount over time.
ETFs offer a simple way to diversify2 your portfolio. You can buy ETFs that mirror a broad market index. You can also invest in ETFs representing specific market sectors, such as tech, health care, and finance; foreign markets; investing styles, such as growth or value; market capitalization; and asset type.
In addition to stocks, bonds, and real estate, ETFs provide investment opportunities in market sectors that individual investors may not be able to access easily, including currencies and commodities. With ETFs, you can use many of the same strategies that are available for individual stocks, such as buying on margin, short selling, and placing limit or stop-loss orders.
Compared to index mutual funds, ETFs that track broad market indexes are typically relatively tax efficient because they make capital gains distributions less often. However, if you hold ETFs in a taxable account, any distributions of interest and/or dividends will be taxable, as will any capital gains distributions that result from a sale of securities that are necessary to mirror the index. Similarly, any capital gain received on the sale of your shares will also be taxable.
Traditional ETFs — the largest category — track indexes that are weighted by market capitalization, assigning the most weight to companies with the highest stock market value. ETFs that track traditional weighted indexes generally have low costs and tend to mirror the way the market itself is weighted.
Alternative-weighted ETFs mirror indexes that take a different approach to weighting stocks. For example, an equal-weighted index gives the same weight to each stock in the index while a fundamental-weighted index uses criteria such as a company’s profits, dividends, cash flow, and number of employees to assign weight to stocks. Similarly, a low volatility-weighted index looks for stocks that demonstrate lower overall volatility compared to the market as a whole.
1 You should consider the fund’s investment objectives, charges, expenses, and risks carefully before you invest. The fund’s prospectus, which can be obtained from your financial representative, contains this and other information about the fund. Read the prospectus carefully before you invest or send money. Shares, when redeemed, may be worth more or less than their original cost.
2 Diversification does not ensure a profit or protect against loss in a declining market.
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