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Editorial Coverage: The world’s first
exchange-traded fund (“ETF”) was created in Canada in 1990,
with the first U.S.-based ETF following suit a few years later. In
those days, these novel investment alternatives were primarily
reserved for institutional investors hoping to capitalize on
sophisticated trading strategies.
Today, ETFs claim a dominant position in the portfolios of
millions of investors attracted to diversification and convenience.
Research by brokerage firm Charles
Schwab suggests that more than nine in 10 millennials consider
ETFs “a necessary part” of their investment strategies. The same
survey shows that more than one in three respondents have changed
their entire portfolios over to ETFs.
“Within a decade, we've seen ETFs grow to the point where
investors now see them as a foundational investment vehicle,”
Heather Fischer, vice president of ETF and mutual fund platforms at
Schwab, noted in a news release. “While this sentiment is
particularly pronounced among millennial investors, it is reflected
strongly across generations and genders.”
What are ETFs?
Thoroughly researching any company in which you plan to invest
is a great idea. Combing through filings and studying industry
trends are tried-and-true ways of predicting the upside of an
investment target. But we’re not all full-time investors capable of
sufficient due diligence. As Investopedia
notes, “[ETFs] have become a popular choice among investors looking
to broaden the diversity of their portfolios without increasing the
time and effort they have to spend managing and allocating their
investments.”
To put it simply, an ETF is a basket of securities that is
traded on a major exchange, such as the New York Stock Exchange or
Nasdaq. Much like a mutual fund, ETFs can contain tens, hundreds or
even thousands of stocks or bonds, but ETFs can also be quickly and
conveniently traded through most online brokers – just like stocks.
Because of their indexed nature, ETFs tend to be more
cost-efficient than actively managed mutual funds while still
facilitating the diversified approach to trading that many
investors prefer.
Choosing an ETF
The ETF market is vast, and it features a near limitless
selection of offerings for prospective investors. Perhaps you’re
interested in dipping a toe into a hot sector such as blockchain or
wireless infrastructure. Maybe you’d prefer a geographically
specific fund focused on the fledgling cannabis industry in Canada.
Regardless of your preference, there is a huge variety of ETFs from
which to choose, and more are being introduced every day.
A few things to consider before choosing an ETF include:
- Underlying Index: A great thing about ETFs is
that they typically disclose their holdings on a daily basis. Check
this list to ensure that the fund’s asset allocation matches your
investment strategy. As ETF.com
notes, you should pay particular interest to how the stocks or
bonds that make up the ETF are weighted. Some indexes weight their
holdings equally, while others favor one or two big names. This
choice can have a major impact on the level of risk associated with
a particular ETF.
- Liquidity: Because of the nature of ETFs,
liquidity can vary greatly from one fund to the next. Look into the
level of
assets held by an ETF, and set a minimum threshold. An ETF with
assets below a threshold of $10 million, for example, may have
limited investor interest and, as a result, poor liquidity. Trading
volume is an excellent indicator of liquidity, and a tight bid-ask
spread is key to maximizing returns when the time comes to exit the
ETF.
- Tracking Difference: Managing ETFs isn’t free,
so it’s important to make sure that the fund on your radar is
reasonably priced. The expense ratio is a good place to start, but
the fund’s tracking difference provides a more accurate
representation of how the ETF is performing in relation to a
particular index. As ETF.com states, “If an index is up 10.25
percent, a fund should be up 10.25 percent too. But that's rarely
the case.” Expenses such as annual fees and transaction costs can
eat into your returns, so remember to do your diligence and
evaluate the ETF manager before you decide to invest.
A Case Study
Armed with a better grasp on the fundamentals of ETFs, let’s
take a closer look at one example to see how it stacks up with the
key considerations outlined above.
The technology sector was recently highlighted as one of ‘9
Sectors That Investors Should Watch in 2019’ by U.S. News,
and many high-profile investors agree. Despite largely avoiding
technology stocks throughout his investing career, billionaire
Warren Buffett noted during the 2018 Berkshire Hathaway meeting
that the international conglomerate had “erred by not buying
Alphabet, parent of Google,” as reported by Money.
Buffett has likewise been investing in Apple since early 2016, and,
today, his Apple stake represents his “single largest holding—by a
factor of two.”
Invesco QQQ (NASDAQ: QQQ) is a prime example of an ETF that
gives its investors significant exposure to the potential upside
presented by the technology sector while remaining diversified. The
fund includes 100 of the largest domestic and international
non-financial companies listed on the Nasdaq Stock Market based on
market capitalization. QQQ is rebalanced quarterly, and
constituents are re-evaluated annually to ensure they make the cut,
with the largest share of assets being devoted to the biggest
stocks within the Nasdaq-100
Index. Currently, roughly 42 percent of
the fund is invested into five tech giants: Microsoft Corp.
(NASDAQ: MSFT), Apple Inc. (NASDAQ: AAPL), Amazon.com Inc. (NASDAQ:
AMZN), Facebook (NASDAQ: FB) and Alphabet Inc. (NASDAQ: GOOGL)
(NASDAQ: GOOG).
Underlying Index
QQQ is a popular choice for those interested in the technology
sector, as it presents a relatively safe
way to find growth. While its focus on the Nasdaq means that
some of the largest tech companies – IBM, Alibaba Group, AT&T,
etc. – are excluded, the inclusion of less volatile, non-tech firms
provides a more balanced investment approach that still reflects
the upside of the market as a whole. Since 2010, QQQ and the
Nasdaq-100 Index have outperformed the wider Nasdaq Composite Index
by more than 35 percent
and the Russell 3000 Index by more than 65
percent.
Because the weighting of shares in QQQ are rebalanced quarterly,
the ETF is also able to minimize the effects of major swings in
particular securities.
In February 2018, Apple shares made up 11.25 percent of QQQ
holdings, but Apple’s price per share (“PPS”) recorded a strong
downward trend
to close out the year. From a 52-week high of $233.47 in early
October, Apple’s shares fell to a 2018 low of $146.83 in late
December.
Likewise, QQQ’s PPS fell from a 52-week high of $186.17 in early
October to a 52-week low of $143.46 in late December. However,
following its quarterly rebalance, which increased holdings in
Microsoft and decreased holdings in Apple, QQQ has recorded growth
of 10.4 percent year-to-date, outperforming Apple shares over the
same period by nearly three percent.
While this short-term trend doesn’t reflect a hard-and-fast
rule, it does highlight the potential upside of the diversification
strategies facilitated by ETFs. By offering a fluid sampling of
some of the technology sector’s most prominent companies, QQQ
provides exposure to technology while limiting the effect of
significant swings in the PPS of individual stocks.
Liquidity
As mentioned previously, the liquidity of ETFs can vary wildly
based on their holdings. With QQQ being comprised of 100 of the
largest domestic and international non-financial companies listed
on the Nasdaq, it is recognized as
“one of the best established and most traded ETFs in the world.”
QQQ is much more concentrated in its top holdings than many
large-cap benchmarks, but its huge name recognition and the
reputability of the underlying Nasdaq-100 Index position it as an
extremely liquid fund.
As noted in an article from
The Street in mid-2018, “This ETF is one of the best as
per liquidity and its tight bid/ask markets.”
Tracking Difference
QQQ offers a total expense
ratio of 0.20 percent, meaning that the fund will cost
investors $2 in annual fees for every $1,000 invested. According to
the Wall Street
Journal, the average ETF carries an expense ratio of 0.44
percent, by comparison. In other words, the fee structure of QQQ is
attractive for those looking to invest in an ETF.
Comparing the performance
of QQQ to the Nasdaq-100 Index paints a similarly inviting picture.
If, for example, an investor put $10,000 into QQQ on December 31,
2008, and held the shares for 10 full years, the investment would
have been worth $57,130 at the end of 2018. This total comes in at
just 2.15 percent less than the growth of the Nasdaq-100 Index over
the same period, according to Invesco data.
Are ETFs Right for You?
To sum things up, ETFs offer a unique pathway for investors
looking to gain exposure to a certain sector or industry without
greatly increasing the time spent researching individual companies.
Their fee structures are typically extremely competitive,
particularly when compared with actively-managed mutual
funds, and they can even provide serious tax benefits
related to capital gains.
If you don’t have any ETFs in your portfolio, now could be the
time to take a closer look at this time-tested investment vehicle.
As Martin Small, head of U.S. and Canada iShares at BlackRock,
noted in a 2018 open letter,
“ETFs aren’t just having a moment. They’re creating a
movement.”
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