In the early days of investing, if someone wanted to make an equity investment, they purchased individual shares of stock, and achieved diversification by purchasing shares of a number of different stocks. Similarly, if an investor wanted exposure to debt, they purchased individual bonds, and achieved diversification through purchasing bonds of various companies, with varying maturities.
Over the past decade or so, ETFs have increased in popularity as funding vehicles for investment portfolios.
The Mechanics of an ETF
When you purchase an ETF you are essentially buying a diversified portfolio of assets within a particular sector, much like an index mutual fund. Unlike mutual funds, which are priced at the end of each trading day, ETFs are priced throughout the trading day, just like stocks. Like stocks, ETFs can be sold short, or can be purchased on margin, allowing additional options for enhancing (or reducing) investment returns. ETFs also tend to be more tax efficient than mutual funds, and their expense ratios (management fees + trade expenses) are generally lower as well.
Investing Based On Long-Term Averages
For the past 50 years, most advisors have relied on how a particular mix of assets perform over the long haul when making investment decisions. The average “moderate” portfolio is typically a 60/40% mix between stocks and bonds. Regardless of whether markets are underpriced, fairly priced, or overpriced, the portfolio doesn’t vary much. This has typically been supported with the explanation that it’s impossible to know where markets are headed. It was believed “staying the course”, according to the asset allocation model dictated by a client’s risk tolerance, established predictability of returns over the long run. This may have been true in the 1950s when mathematical models could not adequately assess the risks in the market.