Mutual funds are found in 88% of all portfolios and have become vital investment tools. By assembling a group of equities, bonds, and other investment tools under the same umbrella, a mutual fund offers diversification and lowered risk. While high expense ratios, tax liabilities, penalties for selling early, being able to trade only once a day are all potential issues with mutual funds, they are still a vital part of most portfolios.
Exchange-traded mutual funds, or ETFs, on the other hand, are not nearly as common as mutual funds or stocks despite the fact that they share qualities with both. ETFs basically mimic the major indexes, such as the S&P 500 or NASDAQ. However, even though an ETF tracks an index, it is traded more like a stock and can be bought and sold throughout the day - or traded intraday. A mutual fund must have its net asset value, or NAV, calculated every day before shares in it can be bought or sold. Because ETFs function like two very different investment tools, some investors do not understand how best to use them in their portfolios.
ETFs can be used by investors to diversify their portfolio with index investing. One common misperception about ETFs is that they are limited to equities, such as those comprising the Dow Jones Industrials. However, ETFs have been created that mimic nearly every index in nearly all investment sectors. For those more comfortable with fixed-income investments, there are ETFs that mirror the major bond markets - both short and long-term.
Actually buying into all of these indexes would require large sums of money that would need to be tied-up for extended periods of time. With ETFs, however, investors can gain the diversification and traditional earnings of the major indexes without the commitment. Those indexes are benchmarks and people add them to their portfolio as long-term investments because they tend to yield reliable returns - year in and year out. ETFs can be purchased so that a portfolio is diversified with indexes from all major sectors, adding both long-term security and the flexibility to adjust those holdings in the short-term without major hassle or expense.
An investor could easily purchase 6 or 7 ETFs that would cover most of the equity market while still having enough to invest in the bond market as well. By using a buy and hold strategy, an investor could add to these holdings each year and enjoy performance in line with the indexes known for their overall reliability and steady earnings. Although they trade like stocks, ETFs can diversify your portfolio and be used as long-term investments.
However, if you already have a portfolio with some solid mutual funds, bonds, and equities, then you may be able to further diversify your holdings with ETFs by investing in specialty or niche areas. Small-cap investments tend to be high risk, but can also be very profitable as they can grow quicker than the larger companies. There are ETFs for small-cap companies that will lower your risk but still provide the potential for higher returns than are typical for large-cap companies.
ETFs can be used in your portfolio to move into and out of entire markets or sectors with reduced risk and expense. In addition to small-cap opportunities, ETFs also are offered in areas like commodities, specialty niche markets (e.g. biotech), and almost any sector imaginable. So for people who like to ride the most recent investment trends but don't want to be burnt when things go south, ETFs are a great short-term tool to have in your portfolio.