Etfs: A Beginner's Guide To Exchange-Traded Funds

Exchange-traded funds (ETFs) are a type of investment fund that can be traded on a stock exchange. They are similar to mutual funds in that they pool investors' money to invest in a basket of securities, such as stocks, bonds, currencies, and commodities. However, ETFs are traded like individual stocks, meaning they can be bought and sold throughout the day. ETFs are often designed to track the performance of a specific index, such as the S&P 500 or the Dow Jones Industrial Average. They offer investors a low-cost, tax-efficient, and diversified way to access a broad range of asset classes and markets.

ETFs vs Mutual Funds

Exchange-Traded Funds (ETFs) and mutual funds are both professionally managed "baskets" of individual securities, like stocks or bonds, that are professionally managed. They are similar in that they both offer diversification and a wide variety of investment options. However, there are some key differences between the two.

ETFs trade like stocks and are bought and sold on a stock exchange, meaning their price fluctuates throughout the day. Mutual funds, on the other hand, can only be purchased at the end of each trading day based on a calculated price known as the net asset value (NAV). This means that all investors who bought or sold mutual funds on the same day will receive the same price.

Investment Minimums

ETFs do not require a minimum initial investment and can be purchased for the price of a single share, whereas mutual funds typically have minimum investment requirements ranging from a few hundred to thousands of dollars.

Management Style

Mutual funds can be actively or passively managed. Actively managed funds are handled by fund managers who make decisions on how to allocate assets to beat the market. Passively managed funds aim to mimic the performance of a specific index. Most mutual funds are actively managed, whereas most ETFs are passively managed.

Expense Ratios and Fees

Actively managed funds tend to have higher fees and expense ratios due to their higher operations and trading costs. ETFs usually have lower expense ratios, especially if they are passively managed, as they do not require as much active management. Mutual funds often have higher expense ratios and may also carry sales loads or other charges at purchase or sale.

Tax Efficiency

Mutual funds can generate more capital gains taxes due to the frequent buying and selling of securities within actively managed funds. ETFs, as passively managed portfolios, tend to be more tax-efficient and realize fewer capital gains.

Flexibility

Because ETFs are traded like stocks, they offer more flexibility and can be used for options, shorting, and buying on margin.

Types of ETFs

There are several types of ETFs, each varying in terms of asset type, tax implication, and expense ratio. Here are some of the most common types:

• Equity ETFs invest in various stock assets, usually tracking stocks in a particular industry or in an entire index of equities, such as the Dow Jones Industrial Average (DJIA) or the S&P 500 Index. Equity ETFs may own stocks, generally selected based on company location, sector, or size. Examples of equity ETFs include international ETFs, sector ETFs, dividend ETFs, and market-cap index ETFs.
• Fixed-income ETFs (or bond ETFs) invest in bonds, which are fixed-income securities. Most bond ETFs focus on a specific subset of bonds, such as government or corporate bonds, and are generally lower-risk, helping to reduce a portfolio's volatility.
• Commodity ETFs invest in physical commodities, such as natural resources or precious metals. They give investors ownership of the fund's physical stockpile of a commodity or equity in companies that produce commodities.
• Currency ETFs track the performance of a single currency or a basket of multiple currencies, often backed by bank deposits in a foreign currency. Currency ETFs provide investors with diversification and protection against a depreciating domestic currency.
• Broad stock ETFs are diversified, often giving exposure to multiple sectors (e.g., energy or real estate) and, in the case of international ETFs, several countries. They generally do not rely heavily on the performance of a specific type of company or country.
• Broad bond ETFs invest in different areas of the fixed-income market, such as corporate and government securities, making their returns less dependent on the performance of specific sectors. Examples include government and corporate ETFs.
• Smart beta, factor-based, and fundamental ETFs track an index based on a strategy other than a traditional market-cap-weighted index.
• ESG ETFs (environmental, social, and corporate governance) allow investors to invest in issues that are important to them by incorporating these considerations into their investment approach.

Additionally, ETFs can be classified as either passively managed or actively managed. Most ETFs are passively managed, meaning they are designed to track the performance of a particular index. Actively managed ETFs, on the other hand, involve a portfolio manager making investment decisions for the fund.

How ETFs Work

Exchange-traded funds (ETFs) are a type of passive investment. They are a basket of investments, such as stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments. ETFs are designed to mimic the performance of an underlying index or sector. They are traded on a stock exchange and can be bought and sold like common stock.

ETFs are often compared to mutual funds because they pool investors' assets and use professional fund managers to invest the money according to a specific strategy. However, ETFs are bought and sold on an exchange at a continuously determined price, whereas mutual funds are bought and sold directly from the fund issuer at the fund's net asset value (NAV), which is set at the end of each trading day.

There are two types of ETF: physical and synthetic. Physical ETFs invest directly in whatever they track, for example, a gold ETF invests in gold bullion held in a vault. Synthetic ETFs are more complex and involve purchasing 'swaps' – a type of derivative, usually sold by investment banks – which promise to pay the same returns as the index or underlying investment they track.

ETFs are popular among investors as they are a simple and easy way to get access to investment markets. They are also a good option for those looking to build a diversified but low-cost portfolio. ETFs are easy to track because investors can look up their trading price by checking their tickers.

To invest in an ETF, you can buy and sell via a brokerage firm/broker (including online brokers and robo-advisors) throughout the day on the ETF’s chosen stock exchange. You will typically pay an administrative fee for administrative costs, possible brokerage commissions (depending on your broker) and transaction fees (required by the SEC) for the sale of ETF shares.

Benefits of ETFs

Exchange-traded funds (ETFs) are baskets of investments such as stocks, bonds, commodities, currencies, options, swaps, futures contracts, and other derivative instruments. They are designed to mimic the performance of an underlying index or sector. Here are some of the benefits of investing in ETFs:

Trading Flexibility

ETFs are bought and sold on exchanges during market hours, offering trading flexibility. The pricing of ETF shares is continuous during normal exchange hours, and share prices vary throughout the day based on the changing intraday value of the underlying assets in the fund. This makes it easy to move money between specific asset classes, such as stocks, bonds, or commodities.

Portfolio Diversification and Risk Management

ETFs provide investors with exposure to a wide range of asset classes, including domestic and international stocks, bonds, and commodities. This diversification helps to lower risk and exposure. Additionally, ETFs can be used as a complement to other investments, providing further diversification.

Lower Costs

ETFs typically have lower operating costs than traditional open-end funds or actively managed mutual funds. Most ETFs track broad market indexes, so they don't have to pay portfolio managers to analyze and trade shares for the fund. This makes owning an ETF less costly than owning an actively managed mutual fund.

Tax Efficiency

ETFs are considered more tax-efficient than mutual funds due to their structural differences and lower turnover. ETFs often mirror index mutual funds, resulting in less frequent trading and fewer taxable transactions. Additionally, capital gains taxes on ETFs are only incurred upon the sale of the ETF by the investor, whereas mutual funds pass on capital gains taxes to investors throughout the life of the investment.

Risks of ETFs

Exchange-Traded Funds (ETFs) are baskets of investments such as stocks, bonds, commodities, currencies, options, swaps, and futures contracts. They are designed to provide instant diversification, allowing investors to gain exposure to different asset classes, industry sectors, and geographic regions. While ETFs offer many benefits, they also come with certain risks that investors should be aware of. Here are some of the key risks associated with ETFs:

Underlying Asset Risk

The value of an ETF is influenced by the performance of the underlying basket of investments. For example, a bond ETF is exposed to credit, default, and interest rate risks. It's important to carefully review the risk section of an ETF's prospectus to understand the specific risks associated with a particular fund.

Market Risk

The underlying assets of an ETF may fluctuate in value, leading to potential losses. ETFs that track a broad market index, such as the S&P 500, are generally less volatile than those focused on specific industries or sectors. It's crucial to understand the underlying risks associated with the index or sector an ETF is tracking.

Liquidity Risk

Liquidity refers to the ease with which an investment can be converted into cash without impacting its market price. While ETFs are traded on exchanges, some ETFs based on less liquid underlying assets may have wider bid-ask spreads, impacting the ease of buying or selling the ETF.

Tracking Error

ETFs that track an index aim to deliver similar returns. However, there can be a divergence between the expected and actual returns, known as tracking error. Fees and expenses are usually the biggest contributors to tracking error.

Pricing Differences

The market price of an ETF may not always accurately reflect the exact value of its underlying assets. Investors are exposed to market forces when trading ETFs, and prices can diverge from the net asset value (NAV).

Tax Consequences

While traditional ETFs may provide tax efficiency through fewer capital gains distributions, non-traditional ETFs with daily resets can result in more frequent trading. This can lead to significant short-term capital gains that may not be offset by losses, impacting the overall tax efficiency.

Redemption

Retail investors typically need to redeem shares of an ETF by selling them through a broker on the secondary market, unlike mutual funds that can be sold back to the fund issuer.

Fees

ETFs generally charge management fees, also known as expense ratios or investor fees, which are deducted directly from the fund's assets. These fees typically range from 0.1% to 1%. Additionally, brokerage commissions and transaction costs are usually incurred for ETF purchases and sales. Leveraged and inverse ETFs, due to their volatility, tend to incur substantial brokerage fees and commissions.

It's important to remember that investing always carries some level of risk, and it's essential to carefully consider and understand the risks associated with any investment product, including ETFs, before making any financial decisions.

Frequently asked questions