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Exchange Traded Funds:
Features of Diversified Passive Indexing

Single Stock Risk…
For average retirement investors, owning shares of individual companies may not be the best option. Single stocks are not only vulnerable to conditions of the overall economy, but are also exposed to company-specific risk. For example, though a particular industry as a whole may do well, there could be companies in the industry that make poor business decisions. By trying to pick individual winners, the investor takes on non-market, company-specific risk. However, owning all stocks in the industry would reduce the risk of losses from any single company having a hiccup.

Stock Funds
Funds that hold baskets of stocks can be a good way to limit non-market risk associated with shares of single stocks. Stock funds can hold dozens or even hundreds of companies. If an individual investor bought hundreds of companies’ shares it would be time-consuming and impractical. For decades, investments called mutual funds were the only way average investors could access broadly diversified portfolios without buying lots of company shares. However, in the 1990s, a new product emerged. Though similar to traditional mutual funds, exchange traded funds (ETFs) have key differences.

Buy and Hold
Like mutual funds, ETFs provide diversification through broad-based baskets of stocks. However, the way stocks are selected is different between the two. While mutual funds are typically active, with a fund manager making decisions about what stocks to buy or sell, the holdings of ETFs are determined by an index. Stocks included in the index meet predetermined criteria. Though active fund managers may buy and sell frequently, once a stock is added to an ETF, it remains unless it no longer meets the criteria for inclusion. This buy and hold aspect of ETFs is associated with a passive style of investing.

Low Cost…
The stock selection process affects how much an investor has to pay to own the fund. Funds that hire active managers are typically more expensive than passive index funds. As it is extremely difficult for anyone to consistently beat returns of the overall market over time through active management, passive strategies can be a good choice for long-term retirement investors. Even if an active fund outperforms a comparable index, the management fees may cancel out much or all of the extra gains. Other than cost, another difference is indicated in the ETF name. While mutual funds are only bought or sold after markets close using their end of day value, ETF transactions happen on the same exchanges as stocks and can be made any time during market hours. ETFs can be a convenient, cost-effective way to build a long-term, diversified portfolio for retirement investors.

October 5, 2022

Markets Demystified is published the first and third Wednesdays of each month,
and explores how stock market investing can relate to personal finance.

Thanks for Reading!

Jonathon Oden
Owner | Aesop Advisor LLC

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