Apparently nothing can ever be simple on Wall Street. Take the case of a simple question like "should I invest in ETFs?" A beginning investor can spend less than 10 minutes on Google (Nasdaq: GOOG) and learn (if that is the right word to use) that exchange traded funds (ETFs) are the greatest invention since fire, the worst thing since the Yugo, or "investing in ETFs involves risks and may or may not be appropriate for your individual situation; please consult an advisor." (For a background, see our Introduction To Exchange-Traded Funds.)
While it is true that everybody's financial situation is different, here are some advantages of ETFs relative to stocks and mutual funds for beginners to consider.
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Less Due Diligence
The iShares U.S. Medical Devices ETF (NYSE: IHI) contains 40 different stocks. It would take weeks for an individual investor to do proper due diligence on each of those names, and that is one of the advantages of ETF investing. Because the impact and importance of any one stock is relatively small, investors can spend their time thinking about which sectors and markets are poised to perform and make investment choices without being bogged down by an overwhelming amount of initial and ongoing due diligence.
ETFs Might Be Cheaper
Whether you compare them to mutual funds or individual stocks, ETFs can be cheaper to own and trade. Many major brokerages now offer a selection of ETFs that investors can trade commission-free, and that gives them a cost advantage relative to individual stocks. Many ETFs, particularly index-type ETFs, have lower annual expenses than comparable mutual funds and can be cheaper to hold.
While it is possible to find quality mutual funds with low minimum initial investment requirements, ETFs have no such requirements at all. If an investor has $100 to invest and has an account with a broker that offers free ETFs, it is possible to put that money to work immediately. Likewise, there are no minimums for subsequent investments and no minimum "maintenance" amounts.
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ETFs provide instant diversification relative to individual stocks. It would be challenging to have a properly diversified portfolio with 10 individual stocks, but it's relatively simple with the same number of ETFs. (To learn more, see 10 Ways ETFs Can Grow Your Portfolio.)
Invest In Hard-To-Access Markets
Owning gold is a pain for most individual investors; owning SPDR Gold Shares (NYSE: GLD) (which owns gold bullion) is simple. Not only does this ETF bypass the bid-ask spreads of retail gold and the expense of rolling over futures contracts, it has no storage or security requirements. Likewise, investors can access commodities like copper, precious metals, timberland and so on through the convenient forms of ETFs. (For more, check out Commodities: The Portfolio Hedge.)
Can Buy Insurance
Because they are for all intents and purposes stocks, ETFs offer more sophisticated options for experienced investors - particularly when it comes to insurance. If you own the S&P 500 SPDR (NYSE: SPY) (an ETF that mimics the S&P 500), you have broad exposure to the U.S. stock market. If you are worried about a decline in the market, though, you can also buy put option contracts to cover some or all of that exposure. This helps ensure your position against loss (though at a cost ... just like insurance) and is not really an option with mutual funds.
Pairs trading is only for sophisticated investors, but it is another strategy that ETFs can enable. Pairs trading involves buying one security and shorting a similar security; for instance, buying a stock like Merck (NYSE: MRK) and simultaneously shorting Pfizer (NYSE: PFE). The idea is to profit from the relative difference in fortunes between the two companies, but investors can use ETFs to pairs-trade by buying or shorting "the industry" and taking an opposite position in a particular company that the investor believes will do better/worse than the industry. (To learn more, see Give ETF Pairs Trades A Chance.)
The Bottom Line
There is no such thing as a perfect investment, so investors need to accept that any idea will have its flaws and drawbacks. Still, ETFs do stand apart as an investment category with some real positives for individual investors. As a cost-effective way to achieve a broadly diversified portfolio, including hard-to-own (but worthwhile) assets, ETFs are hard to beat. Accordingly, almost any investor may find that ETFs can play a useful role - whether in place of or amidst a portfolio of stocks and bonds. (For more, see How To Use ETFs In Your Portfolio.)
Use the Investopedia Stock Simulator to trade the ETFs mentioned in this article, risk free!
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