Exchange Traded Funds (ETFs) have become increasingly popular over the past decade as a simple and cost-effective way for investors to gain exposure to a wide range of financial markets and asset classes. Despite their popularity, many people are still unclear about what an ETF actually is and how it works.
In this article, we will provide a detailed introduction to ETFs, including what they are, how they are structured, and the benefits and risks of investing in them. Whether you are a seasoned investor or a complete beginner, this article will give you a solid understanding of ETFs and how they can fit into your investment portfolio.
So, if you’re a beginner looking to invest in ETFs, or just curious about how they work, read on to learn everything you need to know about ETFs.
Table of Contents
What is an exchange-traded fund?
An exchange-traded fund (ETF) is a marketable security that tracks an index, a commodity, a bond, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange.
ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
As of 2011, there were over 600 such ETFs available on U.S. exchanges with an aggregate market value of $1 trillion. By May 2008, ETFs had surpassed hedge funds and accounted for more than 25 percent of the assets held by institutional investors.
The first US ETF was the Spider (spiders = S&P Depositary Receipts, which tracked the S&P500), launched by the American Stock Exchange in 1993.
ETFs are similar to traditional mutual funds, but they differ from each other in several ways:
- ETFs trade throughout the day which is based on supply and demand.
- ETFs have lower fees because they do not use legwork to find buy/sell opportunities like mutual funds, hence their returns are more consistent.
- Mutual funds typically require a lump sum payment while ETFs trade like stocks meaning that you can make small purchases over time.
ETFs are fairly new securities that have only been in existence for about 20 years. Although they are rapidly growing in popularity among investors, there are still many myths surrounding ETFs that need to be debunked.
Myths are common in newly introduced financial products, especially when they are not yet fully understood. ETFs are no different.
Many investors have been told by others that ETFs are not a good investment vehicle, but these accusations couldn’t be further from the truth. They are perfectly acceptable investments, but it is important to know the facts about them before making any decisions.
The Popularity of Exchange-Traded Funds
ETFs are one of the world’s fastest-growing investment tools. Over the past few years, they have become very popular among investors because they offer easier access to diversified portfolios with lower fees. This is why it is no surprise that the assets in ETFs have increased from $290 billion in 2005 to over $1 trillion in 2012. This rapid growth is expected to continue, given the advantages that ETFs offer investors.
Types of Exchange-Traded Funds
There are several types of ETFs available to investors, each with its own unique characteristics and benefits. Here are some of the most common types of ETFs:
1. Index ETFs
Equity ETFs invest primarily in stocks and are designed to track a specific stock market index or sector. Equity ETFs are often used by investors to gain exposure to a specific market or industry without having to invest in individual stocks. Some popular equity ETFs include the SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500 index, and the Invesco QQQ Trust (QQQ), which tracks the performance of the NASDAQ 100 index.
2. Fixed Income ETFs
Fixed-income ETFs invest primarily in bonds and other debt securities. These types of ETFs provide investors with exposure to the bond market and can be used to generate income or to diversify a portfolio. Some popular fixed income ETFs include the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which tracks the performance of investment-grade corporate bonds, and the Vanguard Total Bond Market ETF (BND), which tracks the performance of the broad bond market.
3. Commodity ETFs
Commodity ETFs invest in physical commodities such as gold, oil, or agricultural products. These types of ETFs provide investors with exposure to the commodity market without the need to purchase and store physical commodities. Some popular commodity ETFs include the SPDR Gold Shares ETF (GLD), which tracks the price of gold, and the United States Oil Fund (USO), which tracks the price of crude oil.
4. Currency ETFs
Currency ETFs invest in foreign currencies and are designed to track the performance of a specific currency or basket of currencies. These types of ETFs can be used by investors to gain exposure to the foreign exchange market and to hedge against currency risk. Some popular currency ETFs include the Invesco CurrencyShares Euro Trust (FXE), which tracks the performance of the euro, and the Invesco CurrencyShares Japanese Yen Trust (FXY), which tracks the performance of the Japanese yen.
5. Inverse ETFs
Inverse ETFs are designed to provide the opposite return of a specific market or index. These types of ETFs can be used by investors to hedge against a market downturn or to profit from a decline in the market. Inverse ETFs are typically more complex than traditional ETFs and may not be suitable for all investors.
6. Leveraged ETFs
Leveraged ETFs are designed to provide a magnified return of a specific market or index. These types of ETFs use financial derivatives to amplify the return of the underlying asset. Leveraged ETFs can be used by investors to increase their exposure to a specific market or index, but they also come with a higher level of risk than traditional ETFs.
ETFs Vs. Mutual Funds: What’s the Difference?
Exchange Traded Funds (ETFs) and mutual funds are two popular investment vehicles that allow investors to pool their money together to invest in a diversified portfolio of securities. While both ETFs and mutual funds share many similarities, there are also some key differences between the two. Let’s compare ETFs and mutual funds, and highlight some of the key differences between these two investment options.
Structure and Trading
One of the biggest differences between ETFs and mutual funds is their structure and the way they are traded. Mutual funds are typically bought and sold through the fund company at the end of the trading day at the net asset value (NAV) price. In contrast, ETFs are traded throughout the day on an exchange like a stock, meaning they can be bought and sold at market prices that may differ from the NAV price.
Fees
Another important difference between ETFs and mutual funds is the fees. ETFs generally have lower expense ratios than mutual funds, as they are often passive investments that track an index rather than relying on an active manager. However, investors may also incur trading fees when buying and selling ETFs, which can add up over time.
Taxes
ETFs and mutual funds are also taxed differently. Mutual funds may be subject to capital gains taxes when the fund manager sells securities within the portfolio, which can trigger a tax liability for investors. ETFs, on the other hand, generally have a more tax-efficient structure due to the way they are created and redeemed. When an ETF is sold, the investor typically sells it to another investor on the open market, rather than the fund manager selling securities within the portfolio, which can help minimize capital gains tax liabilities.
Transparency
Another difference between ETFs and mutual funds is the level of transparency. ETFs are typically more transparent than mutual funds, as they disclose their holdings on a daily basis, allowing investors to see exactly what securities the ETF is holding. Mutual funds, on the other hand, are only required to disclose their holdings on a quarterly basis.
How to buy exchange-traded funds?
Buying exchange-traded funds (ETFs) is a relatively straightforward process. Here are the steps to follow:
- Determine your investment goals and risk tolerance: Before investing in any ETF, it’s important to determine your investment goals and risk tolerance. This will help you choose the right ETF that aligns with your investment objectives.
- Choose an online broker: You need to have a brokerage account to buy and sell ETFs. There are many online brokers available, and you can compare their fees and features to find one that suits your needs.
- Research and choose the ETFs: Once you have a brokerage account, you can research different ETFs and select the ones that align with your investment goals. Some factors to consider when choosing an ETF include its expense ratio, performance, holdings, and investment strategy.
- Place an order: Once you have selected the ETFs you want to invest in, you can place an order through your brokerage account. You can either place a market order or a limit order. A market order will execute the trade at the prevailing market price, while a limit order allows you to set a specific price at which you want to buy the ETF.
- Monitor your investment: Once you have bought an ETF, it’s important to monitor its performance regularly. You can track the ETF’s performance through your brokerage account or by using a financial news website or app.
It’s important to note that ETFs can carry risks, including market risks, sector risks, and liquidity risks. Therefore, it’s important to do your due diligence and understand the risks associated with each ETF before investing. Also, it’s essential to have a long-term investment perspective and not make any impulsive decisions based on short-term market fluctuations.
The bottom line
Exchange-traded funds (ETFs) are investment funds that are traded on stock exchanges. They offer investors a convenient and cost-effective way to diversify their portfolios and gain exposure to a wide range of assets, such as stocks, bonds, and commodities.
ETFs have gained popularity in recent years because of their low fees, flexibility, and transparency. They can be bought and sold like individual stocks and offer investors the ability to invest in a diversified portfolio of securities with just one transaction.
ETFs are also a great tool for passive investors who want to invest in the stock market but don’t have the time or expertise to pick individual stocks. By investing in a broad-based index ETF, they can achieve market returns with minimal effort and expense.
However, it’s important to note that not all ETFs are created equal. Some ETFs are more complex than others and may carry higher fees and risks. It’s essential to do your due diligence and research the ETF’s investment strategy, holdings, and performance before investing.
Overall, ETFs can be a valuable addition to any investment portfolio. They offer investors a convenient and low-cost way to gain exposure to a wide range of assets and can help investors achieve their financial goals over the long term.
