Portfolio diversification is one of the core principles of investing. Diversification means that an investor should allocate capital to a number of different investments to spread out the risk, rather than put everything down on a single stock or investment. To use a baseball analogy, go for the singles and doubles rather than aiming for the home run and risk being struck out.
While there are numerous types of investments to choose from, an investor still needs a substantial amount of capital to build a diversified portfolio. This capital requirement can be a particular challenge for young investors, as they may have minimal savings to invest. However, exchange-traded funds (ETFs) make it possible to have a diversified portfolio with relatively low investment thresholds. ETFs also have a number of other features that make them ideal investment vehicles for the young investor.
Tutorial: Introduction to Exchange-Traded Funds
Wide Range of ETFs
The first ETFs, that were introduced in the late 1980s and early 1990s, were relatively plain-vanilla products that tracked equity indexes such as Standard & Poor's 500 Index (S&P 500) and the Dow Jones Industrial Average. Since then, the range of available ETFs has expanded to include practically every asset class – stocks, bonds, real estate, commodities, currencies and international investments. There are also a number of inverse ETFs – which trade in the opposite direction to an asset or market – and leveraged ETFs that magnify results two- or three-fold.
For young investors, this extensive range of available ETFs offers a wide variety of investment choices that are not available with index funds. The range of ETFs also means that an investor can build a diversified portfolio with a lower outlay of capital than would have been required in the past.
Consider the case of a young investor who has $2,500 to invest. Let's assume that this investor is a keen student of the financial markets and has some well-defined views on specific investments. She is positive on the U.S. equity market and would like this to be her core investment position. But she would also like to take a small position to back her other views – bullish on gold and bearish on the Japanese yen. While such a portfolio would have required a much higher outlay of capital in the past (especially before the advent of commodity and currency ETFs), she can now build a portfolio incorporating all of her views through the use of ETFs. For example, this investor could invest $1,500 into the Standard & Poor's Depositary Receipts (SPDRs), and invest $500, each, into a gold ETF and short-sell a Japanese yen ETF.
Specific Sector Appeal
Competition among ETF issuers has resulted in the introduction of ETFs that are very specific in focus. Tech-savvy and environmentally-conscious young investors can find specific ETFs that track markets, or segments, that may be particularly appealing to them, such as technology, clean energy and biotech. (For more, see Singling Out Sector ETFs.)
The fact that most ETFs are very liquid and can be traded throughout the day is a major advantage over index mutual funds, which are priced only at the end of the business day. But, this becomes an especially critical differentiating factor for the young investor who may like to exit a losing investment immediately in order to preserve limited capital. The liquidity feature of ETFs also gives investors the ability to use them for intraday trading, similar to stocks.
Investment Management Choice
ETFs enable investors to manage their investments in the style of their choice – passive, active or somewhere in between. Passive management, or indexing, simply involves investing in one or more market indexes, while active management entails a more hands-on approach and the selection of specific stocks or sectors in a bid to "beat the market."
Young investors who are not altogether familiar with the intricacies of the financial markets would be well-served by using a passive management approach initially, and gradually moving to a more active style as their investing knowledge increases. Sector ETFs enable investors to take bullish or bearish positions in specific sectors, or markets, while inverse ETFs and leveraged ETFs make it possible to incorporate advanced portfolio management strategies. (For more, read Is Your Investment Style Hot, Or Not?)
Keeping Up with Trends
One of the principal reasons for the rapid growth of ETFs is that their issuers have been at the leading edge in terms of introducing new and innovative products. ETF issuers have generally responded rapidly to demand for products in red-hot sectors. For example, numerous commodity ETFs were introduced during the commodity boom of 2003-07. Some of these ETFs tracked broad commodity baskets, while others tracked specific commodities such as crude oil and gold.
In 2006, the First Trust IPOX-100 Index Fund became the first ETF to track the performance of U.S. initial public offerings (IPO). While the investment merit of IPOs is a topic that attracts considerable debate, this ETF is another example of the unique appeal of niche ETFs.
The dynamism and innovation displayed by ETF issuers is another feature that is likely to appeal to young investors. As new investment trends get under way and demand surfaces for even newer investment products, there will undoubtedly be ETFs introduced to meet this demand.
Young investors should also be aware of the negative features of ETFs. A major drawback is the fact that, as with a stock transaction, commissions are payable on each ETF trade. This is also likely to be a deterrent for periodic investments in an ETF. In an index fund, or mutual fund, periodic investments of $50 or less are possible, an investment threshold that may be very attractive for the cash-strapped young investor.
Overall, the many advantages of ETFs such as their wide range, sector appeal, liquidity, investment management choice and innovation make them ideal investment vehicles for young investors. (To learn more, check out our Investopedia Special Feature: Exchange Traded Funds.)