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Types of Investments — ETFs

What they are

Exchange-Traded Funds (ETFs) are investment companies that typically track the yield and return of an index, such as the S&P 500, the Dow Jones or the Russell 2000. They are traded like individual stocks on a stock exchange, meaning the price can change throughout the day — unlike a mutual fund, the shares of which are sold once a day at net asset value (NAV) (generally 4:00 p.m. Eastern Time).

How they work

An ETF is a basket of securities that trades like a stock.  The fund offers and issues its shares at their NAV only in aggregations of a specified number of shares known as “creation units”.  Shares are then bought and sold intraday at market price unlike a mutual fund whose shares are sold once a day at NAV (generally 4:00 p.m. Eastern Time).  As a shareholder, you won’t directly own nor have any direct claim to the ETFs’ investments, but you’re entitled to a portion of the profits. Often those profits are earned interest or paid in regular dividends.

Because ETFs are traded on public stock exchanges, an ETF’s ownership can easily be bought, sold, or transferred.

Advantages and disadvantages

Like most investments, there are advantages and disadvantages to investing in ETFs.

Advantages

By owning an ETF, investors get the characteristics of both stocks and mutual funds in a combined investment vehicle with some added buying and selling flexibility.

  • Trading flexibility. Because ETFs are traded like stocks on stock exchanges, they can be bought or sold throughout the trading day and investors can take advantage of price fluctuations.
  • Diversification. Investors get the benefits of diversification, much like mutual funds. One ETF can invest in hundreds or thousands of stocks or bonds in a single fund.
  • Lower fees. ETFs are generally passively managed.  Thus, the fees for many ETFs are lower than those of the average mutual fund.
  • Low investment minimums. Many mutual funds have minimum investment requirements of $2,500 or more. ETFs, on the other hand, can be purchased for as little as the price of one share.
  • Tax advantages. ETFs continuously offer and sell shares through a daily in-kind purchase-and-sales process to authorized participants and not to investors.  As a result, the ETF does not incur tax when securities are sold and investors do not incur capital gains taxes until they sell their shares.
  • Transparency. Typically, ETFs disclose their holdings to the public every day.  This enables investors to observe the fund’s share price and underlying value and attempt to profit from the discrepancy between the two.

Disadvantages

  • Trading costs. ETFs are bought and sold at market price which may differ significantly from the ETF’s NAV and are not individually redeemed from the fund.  Only “authorized participants” can purchase and redeem directly in the funds creation units, typically consisting of a block of 50,000 shares.  Since ETFs are traded on an exchange they are bought and sold through a brokerage account anytime during exchange hours.  An investor purchasing or selling shares in an ETF typically pays a brokerage commission on each transaction which can vary and which could reduce the investor’s returns.  Additional trading-related costs such as spread costs and premiums/discounts can also be incurred when transacting in an ETF. The spread is the difference between the price an ETF is offered for purchase and the price an ETF can be sold.  The premium/discount is when the ETF trades at a price higher (premium) or lower (discount) than the fund’s NAV.
  • Potentially higher fees. Not all ETFs are low cost. Actively managed ETFs generally have higher fees than passively managed ETFs. Make sure you look carefully at the fees of the specific ETF you’re interested in.
  • Price swings. Stock markets can be volatile, and price swings can be frequent — which means your ETFs, like mutual funds, could lose all or a substantial amount of value in a very short time.
  • Not guaranteed. Like mutual funds, ETFs are not guaranteed to return anything to an investor.

Types

Only available in the U.S. since 1993, ETFs have grown to be the most popular type of exchange-traded product.  By the end of 2015, approximately 1,800 ETFs addressed a broad array of market sectors and trading strategies, including index, stock, bond, commodity, and currency ETFs. While index ETFs are most numerous, actively managed ETFs have been available in the U.S. since 2008.

Diversify to avoid risk

A typical investing mistake is to concentrate a large percentage of your money into one investing type. To reduce risk, many investors diversify — which means they spread their investment dollars strategically among different assets and asset categories. Here are 3 ways to diversify.

How you can invest with Wells Fargo Advisors

If you’re looking to invest in ETFs, any of our Financial Advisors can help you create a manageable, adaptable plan for navigating your financial future — delivering consistent, practical advice and guidance. If you have a WellsTrade® account, you can sign on and find ETFs in the drop-down menu from the “quotes and research” tab under “Brokerage.”

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Risk Considerations:

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. There is no assurance any investment strategy will be successful or that a fund will meet its investment objectives. ETFs are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. ETFs seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.  ETFs that focus on a particular sector, country, region, theme or idea may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular sector country, region or industry.

Shares of ETFs are bought and sold at market price which may differ significantly from the ETF’s NAV and are not individually redeemed from the fund.  Only “authorized participants” can purchase and redeem directly in the fund’s creation units, typically consisting of a block of 50,000 shares.  Ordinary brokerage commissions for purchases and sales may apply which could reduce returns.

Stock exchange

A stock exchange is a market in which securities, such as stocks and bonds, are bought and sold.

Dividends

A dividend is a sum of money paid regularly (often quarterly) by a company to its shareholders out of its profits (or reserves).