Exchange Traded Fund (ETF)

A basket of securities that can be bought and sold through a brokerage firm on a stock exchange

An ETF can be described as a basket of securities that can be bought and sold through a brokerage firm on a stock exchange. 

Exchange traded funds

The first ETF was created in Canada in 1990, eventually transforming the investment ecosystem by offering the advantages of merged investing and trading flexibility. 

As of 2021, ETFs have an estimated value of 5.83 trillion dollars, with around 2,354 ETF products traded on the US stock exchange.

ETFs work by keeping track of a market index or commodity. Those tracking a market index are called index funds. ETFs can also be managed by an active fund manager whose aim is to outperform a benchmark index by carefully selecting their stocks.

The expense ratio is a fee that the investors pay to the fund house for managing their money. The expense ratio for passively managed funds is much lower than for active funds that try to beat the market

Types of Exchange traded Funds

Newspaper

  • Bond ETFs: Aims to bring exposure to virtually every type of bond available; US Treasury, corporate, municipal, international, high-yield, and several more

  • Commodity ETFs: Designed to provide exposure to a specific industry, such as oil, pharmaceuticals, or mining.

  • Foreign market ETFs: Created to track non-US markets like Japan's Nikkei Index or China's Shanghai SE Composite Index.

  • Actively managed ETFs: Designed to outperform an index instead of simply tracking one.

  • Inverse ETFs: Designed to make a profit from a decline in the underlying market or index.

  • Exchange-traded notes (ETNs): Unsecured debt securities that are issued by financial institutions. They do not provide their holders control of the asset but instead receive the return that the index generates.

Candlestick pattern

Among these various types of ETFs, the actively managed one is an effective investment strategy that has brought forward several benefits. 

The underlying concept here is that a fund manager will adjust the fund's investments as desired while tracking the index like a passively managed ETF aims to do.

The active fund manager will aim to beat a benchmark through research and strategies.

What are the benefits of using ETFs?

They bring numerous advantages to investors regarding investment choice, ease, and expense. Moreover, they also consist of a basket of stocks and various securities, eventually making them low-risk investments.

Growing

Below are some of the most common perks of ETFs:

1. Diversification

Whenever we buy an ETF, we simultaneously purchase hundreds or even thousands of different securities in a single trade. This practice spreads the risk of investing. 

Making use of ETFs further allows an investor to quickly and easily build a portfolio that comprises a variety of asset classes.

2. Accessibility

They require low investments, meaning that anyone looking forward to getting started can do so with little money. A person can build his portfolio of ETFs with only a few hundred dollars.

3. Cost-Effectiveness

ETFs can be cost-effective in many ways. To give a clear example, let's say you go and buy all 500 stocks that make up the S&P 500. In that case, it's compulsory to pay the broker every time a stock purchase is made.

These fees, when summed up, can put a toll on the total return from investments. This is where ETFs play an essential role as they allow someone to buy all 500 shares in one go while only paying one brokerage fee, reducing the cost of building a diversified portfolio.

4. Tax-efficient

ETFs are structured to make only minimal capital gains distributions, hence keeping tax liabilities lower for investors.

Is ETFs good for beginner investors?

Investor

They are a popular investment vehicle since they offer investors a plethora of valuable tools and traits, which is especially good for beginning investors. Below are some of the reasons why beginning investors should consider using ETFs.

  • Low minimum investment: The minimum amount of investment for Exchange-traded funds consists of only the cost of one share, which usually costs from a few dollars to a couple of hundred. 

Comparing this initial investment with that of a mutual fund which can run into several thousand, ETFs are a better choice for beginners.

  • Own the market: ETFs allow investors to take ownership of popular indexes, for instance, the S&P 500, hence letting them own the market and get the market return, averaging about 10% annually over time.

  • Diversification: ETFs also bring the benefit of diversification for any beginner investor. Beginners can invest in a single fund and purchase shares in a selected group of businesses, concentrated in a single market segment or even the entire market.

This hence allows for a diversified portfolio and thus minimizes risks that come with market volatility.

We can say that ETFs are great for stock market beginners and experts. Their investor-friendly characteristics, such as being inexpensive, available through robo- advisors, and having a low level of riskiness as compared to investing in individual stocks, make them an attractive strategy.

What are the drawbacks associated with ETFs?

ETF trading comes with some drawbacks, which include the following:

Cutting cost

1. Partial shares may not be available

It might be hard for investors to buy partial shares of ETFs. Even if it might not necessarily be a huge setback, it can make investing more complex. For example, an individual wanting to invest $500 every paycheck with a broker that doesn't allow partial investing will need to calculate the number of whole shares he can purchase.

Unlike ETFs, mutual funds make it possible for investors to buy partial shares, meaning that anyone coils invest $500 weekly without any problem.

2. Hidden risks

Considering the variety of ETFs to choose from, a mix of several assets in a single basket of the fund can sometimes prove to be complex and contain risky securities that might not be so obvious at the beginning. Moreover, ETFs are prone to volatility, just like any other investment.

It is hence essential for investors to research ahead on the index the ETF is tracking and get a good understanding of their associated risks.

3. Tracking errors

While an ETF manager or expert always aims to keep their fund's investment performance aligned with the index it tracks, that might not always be easy. There are instances whereby an ETF can deviate from its intended benchmarks due to certain circumstances.

For instance, if the fund manager swaps out assets in the basket of funds, the ETF may not follow the index's performance.

Trading

ETFs V/S Mutual Funds

ETFsMutual Funds
ETFs allow investors to purchase a large number of stocks or bonds in a certain market segment in one goMutual Funds investors pool their money together to invest in a diverse portfolio
ETFs are actively traded on an exchange like stocksThe shares in a mutual fund are acquired directly from the issuing company
They are traded whenever the stock market is open. Prices keep fluctuating.They are priced only once daily based on their net asset value.

 

Understanding the variances between these two investment strategies can have significant implications for investors.

One significant difference to consider between an ETF and a mutual fund is how the shares of the funds are priced.

For ETFs, since they are bought and sold on a stock exchange, market forces directly impact the value of the fund itself. A rise in the demand for the fund means that it could be priced higher than its net asset value.

Likewise, if there is an urgent need to sell the shares of that specific fund, then it could be sold at a price below its net asset value. In contrast, mutual funds are always priced at their net asset value at the end of every trading day.

ETF vs Mutual Funds

A second variation between the two funds is tax efficiency. ETFs are usually more tax-efficient than mutual funds since ETF shares are traded on an exchange instead of being purchased directly with the mutual fund company, so there's a buyer for every seller.

In a mutual fund, this might not be possible since a lot of sellers will lead the mutual fund company to sell shares of the underlying securities. This will result in capital gains tax implications for all shareholders regardless of whether they sell.

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Researched and Authored by Alvin Dookhony | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

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