The debate about exchange traded funds versus mutual funds is an ongoing conversation that likely will never end. There are supporters and detractors in both camps, and as long as these products continue to exist, investors will pour trillions of dollars into both. Each has their advantages and disadvantages, but that’s a discussion for another time. This article will explore some of the things that make ETFs unique, including how they are constructed, the different types of funds available and their historical performance.

ETF Construction

Exchange traded funds are bought and sold just like stocks. They’re so easy to own, they have become a favorite of traders and in the process are making brokerage firms a great deal of money. Why buy a stock when you can trade an entire index or country? It’s become very enticing to professionals and amateurs alike. Easy as it might be, it’s important you know how they’re constructed so you can understand the risks involved.

Briefly, shares of borrowed stocks are held in a trust to mimic a particular index. Creation units are then formed representing bundles of those borrowed shares and finally the trust issues ETF shares, which represent a small portion of the creation units. Those shares are sold to the public. The biggest risk with ETFs is liquidity. Because they can be sold short. if a panic ensued and a particular fund is shorted heavily, and at the same time it experiences severe sell orders, the fund might not have enough cash to satisfy those orders. It’s a hypothetical problem, but one that is certainly possible.

The proliferation of ETFs provides investors with an inexpensive way to achieve global diversification in their portfolios. Whether you want to capture a particular portion of the world’s stocks or all of them, there’s an ETF to make this possible; you can buy a country fund, which invests in the top equities of a particular country, or an emerging markets fund, which invests in a group of countries and the top companies in those markets. Not only are there funds available from a geographic perspective, there are those that use different styles such as value or growth investing. Further still, others invest in differently sized companies; whether you are after a small-, mid- or large-cap fund, there’s something for everyone. However, it’s important that you first determine your portfolio’s equity allocation and then, based on those decisions, select actual ETFs to meet your investment goals.

Fixed-Income Funds

Most financial professionals recommend that you invest a portion of your portfolio in fixed-income securities such as bonds and bond ETFs. This is because bonds tend to reduce a portfolio’s volatility. while also providing an additional stream of income. The age-old question becomes one of percentages. What amount should go to equities, fixed income and cash; this is commonly referred to as asset allocation. Bond ETFs are available in as many types as equity funds, probably more. Investors who are unsure of what type of bond fund to own should consider total bond-market ETFs, which invest in the entire U.S. bond market and provide a one-stop shop.