Index-Based ETFs

Exchange-traded funds (ETFs) are an emerging class of funds that trade like stocks and often follow an index. They can be bought and sold throughout the market day, and they can potentially offer portfolio exposure to the world's leading indexes.

Potential Benefits

For investors and leading financial advisors, exchange-traded funds have become a popular choice for numerous reasons. Here is a brief review of some key advantages:

  • Lower Expense Ratios - The expense ratios of ETFs are generally lower than actively managed mutual funds. Lower costs without sacrificing quality are a key attraction.
  • Tax Efficiency - Many ETFs have low portfolio turnover and low capital gains. For shareholders, this can translate into lower tax liabilities. Consult a tax professional for tax information specific to your financial situation.
  • Trading Flexibility - ETFs trade throughout the market day and can be bought and sold at the click of a button. ETFs also allow the investor to use order types such as limit orders and trailing stop orders to take advantage of price movements.
  • Tactical Investment Strategies - ETFs open a universe of sophisticated investment strategies such as covered call writing, cash management, hedging, tax-loss re-positioning and core/satellite.

Potential Drawbacks

As with any investment, there may be distinct disadvantages to investing in ETFs:

  • Leverage - Some recent ETFs involve the use of leverage. In this situation, leverage means investing with borrowed money. Great care must be used when investing in any leveraged investment because leverage magnifies gains and losses and can substantially increase an investor's risk.
  • Concentration - Some ETFs have a high concentration in just a few underlying assets. There may be no reason to pay an investment firm a yearly fee if you could easily invest in the underlying assets yourself for less money.
  • Homogeneity - High concentration also can result in a lack of diversification in your portfolio, not only in similar companies, but also similar asset types (ETFs that track indexes typically are invested only in stocks). It's important to understand the asset allocation of an ETF before investing in it to ensure you're achieving your desired level of diversification.
  • Options - ETFs have the unique position of having option contracts. While you may find options to be a good fit as an investment or risk management tool, the risks associated with options mean their use might not right for everyone. Options involve special risks that may expose you to potentially rapid and substantial losses. When considering the use of options, you should determine how it fits your own investment philosophy and fully understand the rules and requirements.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange-Traded Fund (ETF) carefully before investing. Leveraged and Inverse ETFs may not be suitable for all investors and may increase exposure to volatility through the use of leverage, short sales of securities, derivatives and other complex investment strategies. These funds' performance will likely be significantly different than their benchmark over periods of more than one day, and their performance over time may in fact trend opposite of their benchmark. Investors should monitor these holdings, consistent with their strategies, as frequently as daily. A prospectus contains this and other information about the ETF and should be obtained from the issuer. The prospectus should be read carefully before investing.

Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.888options.com). All option accounts require prior approval by Scottrade. Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.

The information and content provided in the Scottrade® Knowledge Center is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.