Exchange traded funds (ETFs) were first introduced to institutional investors in 1993. Since then they have become increasingly acceptable to both advisors and investors due to their ability to allow greater control over the construction of the portfolio and the diversification process at a lower cost. You should consider making them a building block for the foundation of your personal investment portfolio.

1. Better diversification: Most people don’t have the time or skill to track every stock or asset class. Inevitably, this means that an individual will gravitate toward the area in which they feel most comfortable, which can result in an investment in a limited number of stocks or bonds in the same business or industry sector. Think of the telecommunications engineer who works at Lucent who bought stocks like AT&T, Global Crossing, or Worldcom. Using an ETF to buy a central position in the market as a whole or in a specific sector provides instant diversification that reduces portfolio risk.

2. Improved performance: Research and experience have shown that more actively managed mutual funds often underperform their benchmark. With fewer tools, limited access to institutional research, and the lack of a disciplined buy / sell strategy, most individual investors perform even worse. Without having to worry about picking individual winners or losers in a sector, an investor can invest in a basket of broad-based ETFs for major holdings and can improve the overall performance of a portfolio. For example, the SPDR for the select consumer staples sector was down 15% through October 23, 2008, while the S&P 500 was down more than 38%.

3. More transparency: More than 60% of Americans invest through mutual funds. However, most investors don’t really know what they own. Except for a quarterly report showing holdings as of the close of business on the last day of the quarter, mutual fund investors don’t really know what’s in their portfolio. An ETF is completely transparent. An investor knows exactly what it is made of throughout the trading day. And the price of an ETF is available throughout the day compared to a mutual fund that trades at the closing price of the previous business day.

Four. No style drift: While mutual funds claim to have a certain slant, such as large-cap or small-cap stocks or growth versus value, it is common for a portfolio manager to deviate from the core strategy outlined in a prospectus in an effort to boost the assets. yields. An active fund manager can add other stocks or bonds that may increase return or reduce risk, but are not relevant to the sector, market capitalization, or style of the main portfolio. Inevitably, this can result in an investor owning multiple mutual funds with overlapping exposure to a specific company or sector.

5. Easier rebalancing: Financial media often extol the virtues of rebalancing a portfolio. However, sometimes it is easier said than done. Because most mutual funds contain a mix of cash and securities and can include a mix of large-cap, small-cap, or even value-and-growth stocks, it is difficult to get an accurate breakdown of the mix to properly rebalance the mix. target asset allocation. Since each ETF typically represents an index of a specific asset class, industry sector, or market capitalization, it is much easier to implement an asset allocation strategy. Let’s say you want a 50/50 portfolio between cash and the total US stock index. If the value of the S&P 500 (represented by the SPDR S&P 500 ‘SPY’ ETF) fell 10%, it could move 10% of the cash. to return to the target assignment.

6. More efficient in taxes: Unlike a mutual fund that has built-in capital gains created by past business activities, an ETF does not have such gains that it requires an investor to recognize income. When an ETF is purchased, it establishes the cost basis of investing in that particular trade for the investor. And since most ETFs follow a low-turnover buy and hold approach, many ETFs will be highly tax efficient and individual shareholders will make a profit or loss. only when they actually sell their own ETFs.

7. Lower transaction costs: Trading an ETF is much cheaper than a mutual fund. In a mutual fund, there are shareholder service expenses that are not necessary for an ETF. Additionally, ETFs eliminate the need for portfolio research and management because most ETFs follow a passive index approach. The ETF reflects the benchmark index and does not require the additional expense of portfolio analysts. This is why the average ETF has internal expenses ranging from 0.18% to 0.58%, while the average actively managed mutual fund incurs around 1.5% in annual expenses plus trading costs.

To compare the total cost of owning an ETF to any mutual fund, the Financial Industry Regulatory Authority (FINRA) makes a Fund and ETF Analyzer tool available on its website. The calculator automatically provides fee and expense data for all share classes of funds and ETFs. The calculator can be found at: http://apps.finra.org/fundanalyzer/1/fa.aspx.

8. Commercial flexibility and implementation of sophisticated investment strategies: ETFs trade like other stocks and bonds. This therefore means that an investor has the flexibility to use them to employ a variety of trading and risk management strategies, including hedging techniques such as stop loss and shorting, options that are not available in mutual funds. ” long-only “.

Another advantage is the ability to use “reverse ETFs” that can provide some protection against a drop in market or sector value. (A reverse ETF responds in the opposite direction to the performance of the underlying benchmark. So if one wants to minimize the impact of a drop in the S&P 500 index, for example, then one can invest a portion of the portfolio in a “reverse “which will go up when the index value goes down).

Or an investor can tilt their portfolio to “overweight” a particular industry or sector by buying more than one index ETF for that area. By purchasing an index, an investor can position themselves to take advantage of the expected changes in this industry or area without the inherent risks involved with an individual stock.

Some investors marry their individual stocks or mutual funds and don’t want to sell and incur losses and miss out on an expected rally. Another tax-efficient option an investor should consider is to sell the losing security while buying the ETF that represents the industry or sector of the sold security. In this way, the investor can record the loss, collect the tax deduction and continue to position itself in the area but with a more diversified index.

Investors, academics and financial advisers sometimes question the “buy and hold” strategy. Some investors are looking for a more active management tactical approach that can be done with ETFs. Although ETFs represent passively created indices, an investor can actively trade them. There are a variety of trading strategies available to “manage trends.” When an index moves above or below its 50-day moving average or its 200-day moving average, this can be a signal to trade in or out of the ETF. To minimize the trading costs that would be incurred when trading an ETF, an investor can use an ETF wrap program that covers all trading costs. These deals are generally even less expensive than buying or selling multiple individual stocks in a separately managed account or using an actively managed mutual fund.