For many years, investors have tried to diversify their overall portfolios by trying to choose stocks from a diverse set of asset classes. Which is fine, but the problem you generally run into is that you also need to diversify within any given asset class, lest something adverse happen to the company you were betting on. However, as soon as you diversify both within and between asset classes, you are now running a potentially 40+ equity portfolio, and even the active investor rarely has time to do due diligence on the hundreds of companies required to find 40. excellent investments.

Exchange traded funds are the answer. Exchange-traded funds (ETFs) allow you to invest in a group of companies at a time, similar to a mutual fund. The difference is that ETFs are traded directly on a stock exchange just like a stock, they can be bought and sold at any time during the day without penalty, and both can be short and optionally sold, allowing you to take advantage of both the rise as the fall. moves in the market.

Each ETF is designed to mimic an investment in a certain industry, region, or type of stocks. Some examples of ETFs are XLI, XLU, and EWC. These ETFs give investors exposure to the industrial sector of the S&P 500, the utilities sector of the S&P 500, and the entire Canadian equity market, respectively. Similarly, someone who simply wanted to match the returns of the S&P 500 could simply invest in the SPY.

However, if ETFs are so similar to mutual funds, why not just use a mutual fund? There really are a couple of reasons to do it. First, mutual funds have a history of underperforming the stock market as a whole after fees are included. This makes investing in simple “indices” through an ETF that represents a large basket of stocks, such as the SPY, an extremely effective way to match market returns with almost no cost. There are also slight tax advantages with ETFs compared to mutual funds. Mutual funds have to pay capital gains taxes every time they sell one of their holdings, and whenever they have a big wave of redemptions, they have to sell their positions to get the money. This leads to excessive commissions, some of which are passed on to the remaining investors.

Of course, the great convenience that ETFs have over mutual funds should not be underestimated. ETFs can be traded as a share, giving active traders the ability to buy and sell intraday. The ability to sell short was impossible with a mutual fund, but now it can be done. During any bear market, the ability to benefit from falling sectors, as well as their rise, is valuable.

Additionally, ETFs are often optional, so risk can be minimized with hedged calls and protective put options or, if desired, much higher returns can be obtained by buying calls and calls on the ETF. Experienced stock option experts can even use advanced stock option strategies such as iron condors and vertical spreads to increase investment returns.

One thing to keep in mind is that not all ETFs are the same. While some simply have a basket of stocks and use them to keep the value of ETFs close to the benchmark, many use other more exotic strategies, with varying degrees of success. QLD, for example, aims to get roughly twice the return of the Nasdaq Composite Index and is generally quite consistent in doing so. Another similar instrument is the ETN, which is actually a debt-based instrument. While ETNs also aim to earn returns based on a given benchmark, their price is also sensitive to changes in the issuer’s debt rating, and this should be taken into account when investing in them.

ETFs are a powerful tool for both the smart investor and the active trader. Its ability to refine and diversify within a certain industry or region of the world is invaluable when dealing with the large megatrends that periodically occur in investment. Similarly, the ability to trade them like a stock, using techniques like shorting, options, and the various types of orders makes them an invaluable asset for the active trader. For those who believe in the “efficient market hypothesis,” they even allow passive investment in indices at a much lower cost than a mutual fund.