Exchange-traded funds are, arguably, the most successful new financial product in recent memory. Investors around the globe hold more than $1 trillion in ETFs. Assets in ETFs held by U.S. investors have tripled in the past five years to $793 billion.
So what's the big attraction? And what's the best way to fit them into your investment strategy? ETFs are simply mutual funds that trade on exchanges as stocks do. You can use them as a core holding or to fine-tune your investment mix. You can plug holes in your portfolio or get access to exotic securities and far-off corners of the world that historically have been difficult, if not impossible, for the average Joe to crack.
In addition to convenience and flexibility, ETFs offer a number of other advantages:
» ETFs are cheap. While the average annual expense ratio for actively managed mutual funds that invest in large U.S. companies is 1.42 percent, the average for ETFs that invest in similar stocks is just 0.48 percent a year. Nearly all ETFs are index funds -- so they needn't shell out much for managers and analysts who pick securities and they don't trade much, which holds down transaction costs.
» Commissions for buying and selling ETFs are falling. Although investors have traditionally had to pay brokerage commissions to buy and sell ETFs, just as they would with stocks, commissions may soon be history. A price war that started with Charles Schwab has ensnared two of the largest ETF providers, Vanguard and iShares. In coming years, you may be able to buy and sell many, if not most, ETFs without paying commissions.
» ETFs give you more control over your taxes. When an investor wants out of an ETF, she simply sells it into the market. That means the fund never has to sell holdings to raise cash to meet redemptions, which minimizes the chances that you'll receive a year-end capital gains distribution. However, an ETF can only be as tax-friendly as the securities it owns. Interest payments from bond ETFs and dividend distributions from stock ETFs receive the same tax treatment as if you owned the bonds and stocks themselves.
» ETFs open up new investment frontiers. Say you want to make a direct bet on Brazil. You can take your pick among three ETFs dedicated to Brazil. Or maybe you want to pursue a "carry trade" strategy, which involves borrowing money in currencies of countries where money-market yields are low and investing the proceeds in high-yielding currencies. PowerShares DB G10 Currency Harvest (symbol DBV) does that for you.
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