How Does ETF Investing Help Create Long-Term Wealth?

Whether youU+02019re just starting your investing journey or have years of experience, exchange-traded funds (ETFs) might be a suitable addition to your portfolio, depending on your investment goals and risk appetite, according to experts.

ETFs function as a container for individual assets such as stocks and bonds, much like mutual funds. However, they often offer greater tax efficiency and lower expense ratios than mutual funds, which has led many investors to prefer them. 

"Over the past 15 to 20 years, ETFs have evolved significantly," noted Barry Glassman, a certified financial planner and founder and president of Glassman Wealth Services in McLean, Virginia, who is also part of CNBC’s Financial Advisor Council.

In 2022, a notable shift occurred, with investors withdrawing over $900 billion from mutual funds and redirecting approximately $600 billion into ETFs, as per Morningstar. This marked the largest net difference recorded.

 

Benefits of ETF investing

Amidst this trend, CNBC’s FA Council experts share their insights on integrating ETFs into client portfolios. 

One major advantage of ETFs, especially in brokerage accounts where capital gains and dividends are taxed annually, is their tax efficiency. Unlike certain mutual funds that distribute capital gains at year-end, most ETFs do not. "This is a key reason why ETFs are attractive," Glassman explained. Cathy Curtis, a CFP and founder of Curtis Financial Planning in Oakland, California, also emphasizes their role in managing tax impacts, particularly in high-tax states like California.

ETFs also play a vital role in diversifying portfolios and balancing risk and reward. They can be part of a core portfolio, with ETFs tracking broad-based indices like the S&P 500 providing stability, as Kamila Elliott, an Atlanta-based CFP and co-founder and CEO of Collective Wealth Partners, uses them.

On the other hand, ETFs in satellite portfolios offer diversification opportunities, reducing exposure to specific asset risks. Marguerita Cheng, a CFP and CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland, cited a client interested in the video game industry who found a suitable video game ETF.

While ETFs in such specialized areas can be less risky than individual stocks, they still carry the potential for significant losses and gains, given the unpredictability of industry winners, including in sectors like video games.

 

Millennials are bullish on bond-focused ETFs

Millennials are showing a stronger preference for bond exchange-traded funds (ETFs) than older generations, a trend experts caution may not be the most beneficial strategy. According to a Charles Schwab survey, millennials, born from the early 1980s to the mid-1990s, have allocated an average of 45% of their investment portfolios to fixed income. This figure is notably higher than the allocations of Generation X (37%) and baby boomers (31%). 

Furthermore, 51% of millennials are planning to invest in fixed-income ETFs in the coming year, exceeding the 45% of Gen X and 40% of boomers. However, this conservative approach might not align well with the typically longer investment horizon of millennials, explains Ted Jenkin, a certified financial planner and CEO and founder of oXYGen Financial in Atlanta. 

With more time to invest, millennials can generally afford, and should perhaps consider, taking on more risk by favoring stocks, which have historically outperformed bonds over extended periods, notes Jenkin, a member of CNBC’s Advisor Council.

Jenkin advises that millennialsU+02019 current 45% bond allocation might be excessively conservative. He suggests using the "Rule of 120" as a basic guideline: subtract your age from 120 to gauge an appropriate stock allocation. For instance, a 35-year-old would ideally have 85% of their portfolio in stocks and the remaining 15% in fixed income.

Experts believe several factors contribute to millennials’ conservative investment stance. Emotional factors, like the financial scars from the 2008 crisis or the dot-com bubble, could influence their decisions. David Botset, head of strategy and product at Schwab Asset Management, suggests these challenging experiences during formative years might lead millennials to be more cautious investors.

"Loss aversion bias," a tendency to prioritize avoiding financial loss, may also play a role. However, this can be detrimental in the long run as stocks typically drive portfolio growth. Holding too few stocks relative to oneU+02019s investment period could mean missing out on potential retirement income.

Additionally, Jenkin points out that current high-interest rates make bonds and cash more attractive, offering safer investments with decent returns. However, he cautions that despite the appeal of a 5% annual return from safer fixed-income investments, bonds have generally underperformed stocks over the long term.