The idea of pooling investment assets has been around for centuries. Mutual Funds first appeared in the 1920s. But it wasn’t until the 1980s that mutual funds became widely popular with mainstream investors.
In recent years, ETFs have taken off as an alternative to mutual funds.
An exchange-traded fund (ETF) is a “basket” of stocks, bonds, or other financial instruments that gives convenient exposure to a diverse range of assets. ETFs are an incredibly versatile tool that can track anything from a particular index, sector, or region to an individual commodity, a specific investment strategy, currencies, interest rates, volatility, or even another fund.
The most significant practical difference between mutual funds and ETFs is that ETFs can be bought and sold like individual stocks — and mutual funds cannot. Mutual funds can only be exchanged after the market closes and their Net Asset Value (NAV) is calculated. Shares of ETFs can be traded throughout regular market hours, like shares of stock.
Both mutual funds and ETFs have expense fees that can range from low to high. Mutual funds can have front or backend loads or redemption fees in addition to management fees.
ETFs that trade like shares have commissions to buy and sell. But some ETFs are so popular that brokers offer commission-free trading in them.
So Many Choices
The sheer number and variety of ETFs can be a bit mind-boggling. Over the last 20 years, we’ve seen just a couple hundred ETF offerings grow to more than 8,000 worldwide, encompassing more than 10 trillion in assets.
A surprising number of ETFs have failed. They started with an interesting focus (well, “interesting” to somebody) but failed to attract enough interest to remain viable. For this very reason, I avoid narrow niche ETFs that trade with low volume.
I eliminate many ETFs on poor liquidity alone. I’m not interested if there’s not much volume in a product. I don’t want to suffer high slippage from wide bid/ask spreads. I want to get in and out quickly and at fair prices.
To leverage or not to leverage?
Inverse and leveraged ETFs often use derivatives like options, futures, and short-term contracts to achieve 2x or 3x the daily change in the assets they’re intended to track.
These types of instruments have inherent time decay, and they tend to lose value over time, regardless of what happens in the index or benchmark that the ETF tracks. As a result, these products are best for very short holding periods or day trading.
Options on ETFs
Many ETFs have options (puts and calls) available. But even if the ETF itself trades with decent volume, that does not mean that the options meet my criteria for liquidity.
Sometimes I will use long options – puts or calls — if a clear directional move is in play. I also use many of my option premium selling strategies on popular ETFs. Just like with stocks, options can be used with…
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