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ETFs: Prevent confusion and help your clients diversify their portfolios

How well-versed are your clients in exchange-traded funds? ETFs are growing in popularity - and could very well be a viable investment option - but overall education on the subject is a bit lacking. As a result, some clients are overlooking the potential of ETFs, and many advisors aren't working with their clients to incorporate ETFs into their portfolios. Even so, there is value in an ETF - with the right education, of course.

What are ETFs?
For clients that are a little fuzzy on exchange-traded funds, some educational background could prove quite useful.

For starters, ETFs are securities that track indexes. When your client buys a share of an ETF, they are buying into a portfolio that has any number of underlying assets. These are often stocks, bonds, futures, foreign currency or something similar. The ownership is indirect, so your clients will only own shares of the assets, not the assets themselves.

In some cases, the value of an ETF comes as they are bought and sold throughout the day. The goal of an ETF is to be most like its index, whether that be the S&P 500, Dow Jones, NASDAQ or something else.

What are ETFs' pros and cons?
While the nuances of ETFs may be confusing for many clients, their purpose can be better explained through pros and cons. On a positive note, ETFs' benefits include:

  • Diversity - Calling for a diversified portfolio may sound like a broken record, but financial advisors can approach this key concern from a new angle through ETFs. Since an ETF can include a wider range of assets - yet be traded like common stock - it is both diverse and easy to manage.
  • Flexibility - ETFs can be bought and sold in a few different ways. They can be sold quickly for a profit or they can be held onto for a long time.
  • Tax savings - ETFs can also lead to certain tax savings, depending on your client. For example, ETFs can avoid large capital gains distributions or dividends with the right stocks. An ETF's tax implications can be tailored based on its assets.
  • Day trading - Since an ETF can be traded like a stock, your clients can use them for speculative purposes. They can buy or sell based on their assumptions of the market, which can't be said about every component of their portfolio.

On a negative note, ETFs' disadvantages include:

  • Profitability - ETFs can be cost-effective, but they can also only be purchased through a broker. This brings in various fees, commission and other expenses. This can dig away at the profitability of ETFs, depending on where they are purchased.
  • Market watching - Since ETFs are traded on a daily basis, their prices fluctuate throughout the day. This can trick some investors into acting rashly, or closely watching the market even though they have a long-term investment plan in place.
  • Overcomplication - Depending on the assets tracked by the ETF - stocks, for example - investing through the ETF could actually be an overcomplication. This is especially true for low-volume indexes, where it may be smarter to just invest in the stock itself.

Clients find ETFs confusing
Overall, an ETF could be exactly what your client's portfolio needs - but their education on the subject could be holding them back.

This was what was found by a recent study conducted by Fidelity Investments and BlackRock. The two firms polled more than 1,000 individual investors, and the results showed that out of all the non-ETF owners, 61 percent hadn't invested because of a lack of familiarity on the security.

"While ETF investments have more than doubled in the last five years, there is still significant opportunity to raise awareness as more than two-thirds of investors report they have yet to tap the potential benefits of ETFs in their portfolios," said Andrew Brownsword, senior vice president of the Fidelity retail brokerage.

There is a silver lining for ETF investments, however. The study found that 46 percent of current ETF owners intend to increase these investments over the coming three years. Furthermore, younger investors tend to prefer ETFs, while 88 percent feel that ETFs are well-suited for long-term investment strategies.

How to pitch ETFs to clients
ETFs have their positives, and your clients could easily benefit from incorporating these securities into their portfolios. Even so, that will often begin with your intervention.

If you want to talk to your clients about ETFs, it helps to follow three simple steps:

1. Education
Naturally, education is the most important element behind ETF awareness. Talk to your clients about the positives, including the ones listed above. Let them know how ETFs can be worked into a portfolio and how they can be more cost-effective, secure and transparent than other investment vehicles.

2. Goals
The next step is to talk to your clients about their investment goals. This conversation will help narrow down the right ETF for each of your clients. It is important to note that most investors use ETFs for long-term purposes. Since ETFs have many similarities with other investment options, especially mutual funds, understanding your clients' goals is the best way to move forward.

3. Evolution
The last step is an evolution, both on your part and your client's. While ETFs have been around for a while, there are new and unique options hitting the market today - not to mention a wide range of ETF-management tools and other online services. You'll have to evolve your offerings, your experience and your comfort with ETFs if you want to best serve your clients.

Avoid confusion to benefit your clients
All in all, confusion and a lack of education can easily hold back your clients from the right financial investment strategies. Whether that includes ETFs or another vehicle, learning about the ins and outs of each option will quickly allow your clients to diversify their portfolios.

Best of all, it will allow them to do so without feeling overwhelmed, confused or misguided. That is why ETF awareness - and general financial education - should be the first step in any client relationship. It will ensure your clients know your expertise is steering them in the right direction.

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