The coronavirus pandemic has created chaos all over the world, affecting everything from how we shop to how we plan for our retirement. The subsequent recession has made many retirement portfolios lose considerable money in a short amount of time. Many of us are wondering how we can make our portfolios more stable for the future to avoid these kinds of losses.
While all investing comes with some level of risk, some products can help mitigate losses better than others. One investment to consider is the exchange-traded fund, or ETF. Certain Index ETFs in particular can make portfolios more resistant to the drops caused by a recession.
What Exactly Is an Index ETF?
As a group, ETFs are groupings of stocks and bonds that are traded like an equity, in the sense that they can be bought and sold from 9:30am to 4pm every trading day, just like a stock. Traditional mutual funds are only priced once a day, after the close. Investors buy a share in the ETF and then have access to all the diversification of the underlying fund. There are many different types of ETFs, some meant for niche industries, such as renewable energy or tech, while others have very broad focuses. One of the broadest options available to investors is the index ETF, which can be an important tool for retirement.
An index ETF is designed to track a particular index, such as the S&P 500 or the Dow Jones Industrial Average. You cannot invest in these indexes yourself, however, so the index ETF is the next best thing. Investing in an index ETF is equivalent to investing in all the companies contained within the underlying index. These indexes tend to represent the stock market well, so investments in an index ETF more or less follow the trajectory of a market.
You may be wondering if it’s a good idea to invest in index ETFs during a recession if they follow the market. While it may sound counterintuitive, it’s not. The stock market will bounce back from a recession, so when ETFs take a hit, they will eventually recover in time. The risk of not recovering is significantly lower with an index ETF than an individual investment. It is important to keep in mind that various markets (domestic or foreign) can remain depressed occasionally, for a prolonged period of time-like a decade or more. For example, the larger US indices generated essentially a 0% return for the 13-year period from January of 2000 to March of 2013, and the Japanese stock market is still down approximately 45% from its highs back in 1989!
Who Benefits Most from an Index ETF?
Index ETFs can be a good investment for a range of different individuals. Because investing in just one index ETF means putting money toward potentially hundreds of different equities at once, it can be particularly good for beginning investors or individuals who want to take a hands-off approach with their money and let it sit once they invest it. However, people who prefer to invest in individual stocks and do not mind doing the necessary research may not like an index ETF since it affords them very little control over the investment.
An index ETF is ideal for someone who does not have the time or desire to research individual stocks and build a personalized diversified portfolio. The built-in diversification limits risk right off the bat. The other advantage of an index ETF is that it tends to have higher average returns than more traditional conservative options, such as bonds. In other words, an index ETF can maximize returns while limiting risk with a virtually automatic approach to investing.
How Do You Vet an Index ETF?
When vetting an index ETF, you need to look at a few different important points to make sure you are making the best decision.
One of the key things to look at is administrative cost. Sometimes called expense ratios, these costs can quickly cut into profits. Different funds can vary considerably in their administrative costs, so it is always smart to look into the expense. Some of the most popular and trusted index ETFs are low cost, so you should not assume that a low expense ratio means an inferior performance.
Aside from this, you should also take note of past performance and top holdings. As the adage goes, past performance does not indicate future results—but it can be helpful when comparing two options. Also, ETFs will publish the top holdings in their particular funds. Some ETFs offer a more narrow or specific allocation, such as biotech or precious metals, so these will tend to be more volatile in both directions than the broader market index funds.
Of course, another important factor to consider is the trading price. ETFs trade just like stocks, so a lower price equates to your ability to purchase more shares. Since index ETFs tend to follow the direction of the market, purchasing during a recession when shares are at their lowest cost can be a great move—it means you will only gain money once the market recovers. When thinking about price, it is also important to consider any kind of commission involved, which is the per-transaction fee that is usually paid to brokers. Many brokers will offer select ETFs that won’t require you to pay a fee when you buy or sell.