Exchange-traded funds (ETFs) are investment funds for which the fund shares are traded on a stock exchange, much like individual stocks.
It is common for an ETF to be designed to track the performance of a particular index, commodity, bond, or a basket of assets.
Unlike mutual funds, which are only traded at the end of the trading day, ETFs are bought and sold throughout the trading day at market price, which can fluctuate just like the prices of individual stocks.
Characteristics of ETFs
Diversification: ETFs provide investors with an easy way to diversify their portfolios. By investing in an ETF, you’re essentially getting exposure to a small piece of all the assets included in the fund, which could range from a handful to hundreds of different stocks, bonds, etc.
Lower costs: Generally, ETFs have lower expense ratios compared to mutual funds. Since most ETFs are passively managed—meaning they aim to replicate the performance of an index rather than outperform it—management costs are lower. However, investors do incur brokerage fees when buying or selling ETF shares. Also, normal index funds can be an affordable alternative to ETFs for investors looking to keep costs down.
Transparency: ETFs offer a high level of transparency. The holdings of the ETF are disclosed daily, allowing investors to see exactly what the fund owns.
Tax efficiency: ETFs are often more tax-efficient than mutual funds due to their unique structure and the way transactions are executed, particularly in the United States. This can result in fewer capital gains tax liabilities for investors over the course of holding an ETF.
Types of ETFs
Stock ETFs: These normally track specific stock indices like the S&P 500. They offer exposure to the equity market.
Bond ETFs: These invest in bonds and provide regular income from the bond’s interest payments. They tend to be less risky than stock ETFs.
Commodity ETFs: These track the price of a commodity, such as gold, crude oil, or an agricultural product. They allow investors to invest in commodities without having to physically hold the commodity.
Sector ETFs and industry ETFs: These focus on a specific industry or sector of the economy, such as technology, healthcare, or finance, allowing investors to target their exposure.
International ETFs: These offer exposure to foreign markets, providing a way to invest in international stocks and bonds without dealing with the complexities of buying securities at foreign exchanges.
Thematic ETFs: These are built around specific themes, such as environmental sustainability, blockchain technology, or other emerging technologies.
Inverse ETFs: These are tied to a benchmark index, but is constructed to profit if the index goes down and vice versa. Inverse ETFs are also known as short EFTs or bear EFTs. Generally speaking, inverse ETFs tend to have higher fees than traditional EFTs.
Leveraged ETFs: This type of EFT uses financial derivatives and debt to boot the returns of the underlying benchmark index. While a traditional EFT normally strive to track the benchmark index 1:1, a leveraged ETF may target the 2:1 mark, the 3:1 mark, or even higher.
A few points to think about before investing in ETFs
Broker commissions
Most brokers will charge you a commission each time you buy or sell ETFs. If you plan on doing a lot of trading (rather than just buy and hold), the commissions can add up to considerable sums over time. It is important to pick a broker where the commissions, and other costs, are suitable for your trading strategy and wont eat a substantial part of your profits.
Some brokers offer zero-commission ETF-trading, but make sure you take the whole picture into account and calculate what it would cost for your particular trading stategy. Some zero-commission brokers can end up being quite costly due to other charges or issues, such as the payment of order flow (PFOF) where your order is routed to a specific counterparty instead of the market.
No-load mutual funds are typically bought and sold without commissions and can be an good alternative.
The ETFs expense ratio
The expense ratio of an ETF show what percentage of the fund’s total assets are required to cover operating expenses each year. This is not the same as an open fee paid by investors, but is still important to know since it has an impact on performance.
Compared to many other investment vehicles, ETFs are known to have pretty low expense ratios – but you should still keep an eye on this number to avoid the outliners, and savy investors also use it to compare otherwise similar ETFs against each other.
Tracking error
An ETF can be designed to track a certain benchmark index, but there are no guarantees that it will do it well. Tracking error measures how closely an index tracks its benchmark. It is advisable for the prospective investor to learn more about tracking errors, what causes them and what to look out for.
Liquidity
An appealing thing about ETFs is that they are exchange-traded and can be traded throughout the trading day. If you plan on doing some fairly active trading, liquidity will be an important factor to consider. Regretably, it is also one that can be difficult to predict and a high liquidty at the time of purchase does not guarantee that market interest in the ETF will remain high over time.
If the liquidity is low, you will find it more difficult to sell the ETF shares quickly at the price point where you want to exit the position, and you risk suffering from price slippage.
A noticable sign of low liquidity is a large spread between bid price and ask price.
You still need to diversify
Mutual funds and ETFs are often recommended as a way to achieve diversification. Suppose you have a fairly small amount of money to invest. In that case, it can be really difficult to achieve a high degree of diversification if you want to buy equity outright, and the same is true for many other investment choices. With a mutual fund or ETF, you get diversification from day one, even if you invest only a small amount.
With that said, putting all your savings into a mutual fund or ETF and then sitting back is not something I recommend. For starters, the fund itself might be diverse, but having all your money in the same fund will open you up to certain types of risks that should be avoided. Even when you invest in funds, it is best to spread your investment over several funds, and make sure they are managed by different entities and not all leaning towards the same industry, geographical market, etc. Also try to achieve some risk-level diversification within your portfolio by mixing higher risk and lower risk funds.
Conclusion
ETFs offer investors a versatile, cost-effective, and straightforward way to access a wide range of assets and investment strategies. Whether looking to diversify a portfolio, gain exposure to specific sectors, or invest in commodities, there’s likely an ETF that meets those investment objectives. As with any investment, it’s important for investors to conduct thorough research and consider their own financial goals, risk tolerance, and investment horizon before investing in ETFs.