Continue reading to find out answers to these questions: What are ETFs? Are ETFs good investments? Should I make ETFs part of my diversified portfolio?

Have you ever wondered, “what are ETFs?” and how can they impact my investment returns?

Exchange traded funds (ETFs) are set up to mirror the performance of a stock-market index or sub-index. They hold a more-or-less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.

Exchange traded funds trade on stock exchanges, just like stocks. Investors can buy them on margin or sell them short. These funds have gained popularity among investors, mainly because many ETFs offer very low management fees.

What are ETFs: Reasons why investors like ETFs

The MERs (Management Expense Ratios) are generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

ETFs practice this “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.

This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

What are ETFs: When to buy

Some investors decide when to buy an ETF with the help of technical analysis.

Technical analysis is a useful tool, but only if you recognize it as one of many tools. Before making any recommendations or transactions in client accounts, we always look at a chart. However, we don’t look at the chart for a prediction on what’s going to happen. We look to see if the pattern on the chart seems to support the view we’ve formed of the stock, based on its finances and other fundamental factors.

We find it encouraging if the two seem congruent, and they usually do. But sometimes one contradicts the other, and that’s when we know we have to dig deeper, and perhaps wait until the situation clarifies itself.

After all, there’s a large random element in all stock price changes, even ETFs, especially in the short term. When you focus on timing buy and sell decisions to improve your investment results, you are trying to come up with a system that can outguess a random factor. But a random factor is something you can’t outguess.

You can, however, offset the random factor indirectly, by taking advantage of our three-part Successful Investor approach. You can enhance our approach with a simple-but-not-easy tactic: Get used to the idea that, when you decide to include a new investment in your portfolio, you should buy while there’s still some doubt in your mind.

What are ETFs: Considerations for trading

Typically ETFs are more tax-friendly and cheaper than mutual funds, even though they may hold more or less the same stocks.

There are benefits to ETFs, which are similar to mutual funds but trade like stocks. This means that investors can buy or sell during normal trading hours. They can also put stops or limits on their investments. However, every time an ETF is bought or sold, you pay a commission. Many investors already know this process, which is the same as buying or selling stocks. But in the end, these commissions mean ETF investing can get costly if you make a lot of buys and sells.

Additional considerations when trading ETFs:

• ETFs can be volatile, even with the diversification they typically offer.
• Know how broadly diversified the fund is so you can determine its volatility. The broader the ETF, the less volatility in general it will have.
• Know the economic stability of countries when investing in international ETFs.
• Know the liquidity of ETFs you invest in.
• Consider buying ETFs in a lump sum, rather than a number of small amounts, to avoid higher brokerage fees.

Do you feel more comfortable with the concept of investing in ETFs? Share your thoughts with us in the comments.