Investing in a sector rather than an individual stock
In some cases, you may believe in the future of a specific industry, but have concerns about investing in a single stock in a rapidly evolving field. If you’re interested in a sector but don’t want to commit your entire investment to one company, an ETF that is based on a relevant index can help spread your risk within that sector. Diversification doesn’t guarantee a profit or ensure against a loss, of course–the sector itself may be quite volatile or cyclical–but an ETF allows you to make a sector bet without relying on the fortunes of an individual company.
Overweighting a particular strategy or sector
Even investors who hold one or more broad-based stock funds–for example, one that focuses on the S&P 500–sometimes want to emphasize stocks that are strong on some aspect of their fundamentals, or that are in a specific industry. Depending on the index it tracks, an ETF can boost exposure to only those stocks.
Staying invested after selling stock for a tax loss
ETFs can help you maintain exposure to a specific sector of the market after selling a stock. For example, you may have sold a large stock position to realize a capital loss for tax purposes, but still believe the industry as a whole is in for some short-term upward price movement. However, if you buy the stock again within 30 days, you would be unable to take the tax loss, because the two transactions would be considered a wash sale.
Purchasing an ETF based on a relevant index is one way to attempt to participate in any industry-wide volatility. In essence, the ETF serves as a proxy for your former investment until you are able to buy it again if you choose to.
Minimizing taxes
ETFs can be relatively tax-efficient. Because a passively managed ETF trades so infrequently, it typically distributes few capital gains during the year. In some cases, investors found themselves paying taxes on capital gains generated by a mutual fund, even though the value of their fund actually may have dropped. Though it’s not impossible for an ETF to have capital gains, ETFs generally can minimize the ongoing capital gains taxes you’ll pay.
Just how much impact can reducing taxes have over the long term? More than you might think. Even a 1 percent difference in your return can be significant. For example, if you invest $50,000 and earn an average annual return of 5 percent (compounded monthly), you would have a pretax amount of $82,350 after 10 years. Even a 1 percent increase in that return would give you $90,970 at the end of that time.
Using ETFs to reduce expenses
Because they’re not typically actively managed, ETFs usually have relatively low expense ratios. As a result, they can be an effective way to minimize long-term investing costs, especially if you have a lump sum to invest and don’t plan to trade frequently.
Attempting to profit from market timing
Some investors use ETFs to trade in and out of a particular sector rapidly. And because ETFs can be shorted just as an individual stock can, you can use ETFs to act on a belief that the overall market is likely to drop.
Limiting losses
Being able to set a stop-loss limit on your ETF shares can help you manage potential losses. A stop-loss order instructs your broker to sell your position if the shares fall to a certain price. If the ETF’s price falls, you’ve minimized your losses. If its price rises over time, you could increase the stop-loss figure accordingly. That lets you pursue potential gains while setting a limit on the amount you can lose.
Are you looking to diversify your investment portfolio? It’s important to note that while ETFs can offer diversification and potentially lower costs compared to other investment vehicles, they still come with risks. It’s crucial to do your research, understand the underlying assets of the ETF, and consider your own financial goals and risk tolerance before investing. Need help guiding your financial decisions? Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our weekly newsletter with the latest economic news.
Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.