What Is An ETF?

    What Is An ETF: Everything You Need To Know

    Exchange-traded funds (ETF) are becoming more and more popular for investors, with investments quintupling in the past ten years. As of June 2019, over five trillion dollars’ worth of ETF is being exchanged globally. The popularity of ETFs has seen it grow from 0.7 trillion US dollars invested in ETFs in 2008 to over 4.7 trillion US dollars in 2018. As of 2019, 2000 different ETFs are being traded on US exchanges. This popularity may leave some people wondering what an ETF is and why it’s so popular.  

    In this guide, we’ll show you what sets ETFs apart from other investment methods like mutual funds – we’ll also talk about tips for effective ETF investing and find out if investing in an ETF is right for you.

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    Defining ETF

    An exchange-traded fund (ETF) is a type of investment containing several assets in one ‘basket’. This basket of assets could include any combination of stocks, bonds, and commodities that often tracks an underlying index. ETFs are called exchange-traded funds since they’re traded on exchanges. This sets them apart from mutual funds that are only traded once per day on market closing. 

    These baskets of assets can be bought and sold through a broker just like a stock. Similar to a stock, the price of an ETF will fluctuate all day as they’re being bought and sold. This also grants the ETF more liquidity than a mutual fund. 

    Assets contained in an ETF vary; they can be composed of numerous stocks across various industries, or they could only contain stocks from a particular industry. Some ETFs only deal with assets offered in the US, while others also contain assets worldwide. This variety of assets make ETFs a popular choice for diversification.

    ETFs And Mutual Funds: Know The Difference

    ETFs and mutual funds share the similarity of being composed of numerous different securities. Both of them are also regulated by three principal securities laws put into effect after the 1929 market crash. However, these two investment products have several key differences that set them apart. 

    It’s generally more expensive to start investing in mutual funds since they charge a larger initial deposit. Mutual funds are also usually slower to buy and sell since they can only be traded at the end of each trading day. They also generally have higher costs. Fund managers spend money on analysts and research to run these mutual funds, which drives up costs for the investors. Mutual funds are also actively managed, which means the fund manager allocates the assets in the funds.

    Meanwhile, an investor can start investing in ETFs for as little as the cost for one share plus fees. ETFs are more flexible since they can be traded at any point during a trading day. ETFs are generally passively managed and are based on the market index. This allows the costs of ETFs to be lower compared to mutual funds. Another key difference between an ETF and a mutual fund is that ETFs are taxed less since they tend to realize fewer capital gains than mutual funds.

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    How ETFs Work

    Now that we’ve answered the question “what is an ETF?”, it’s time to discuss how an ETF works. An ETF, as discussed above, is a basket of assets curated and owned by a fund provider. The shares in this basket are then sold to investors, granting them ownership of a portion of the ETF. These shares can be traded much like a stock, bought and sold throughout the day. 

    A key difference from investing in the assets themselves is that in the case of an ETF, the investors own a part of the ETF, but not the assets themselves. Although, in the case of stock indices, the investors of that particular ETF will get lump dividend payments for the stocks contained in the index. 

    ETFs are designed to track the value of their underlying asset or index, but they trade at prices determined by the market that usually differ from the assets themselves. Another thing to note is that because of expenses and other factors, long-term returns on an ETF will be different from returns from its underlying asset.

    An exchange-traded fund is valued by something called net asset value (NAV). This is one of the most important things to know about an ETF, summing up all of its assets minus any liabilities, divided by the number of shares outstanding. The NAV is used to provide investors with a reference point to buy and sell. By looking at the NAV when someone offers to buy or sell your ETF, you can compare the offer with the NAV and determine whether the transaction is worth it.

    Types Of ETFs

    Depending on the assets it contains, exchange-traded funds can be split into different types. These different types of ETFs provide options for investors who are looking to diversify their investments. Different types of ETF mean different characteristics of each one, with their own return and risk profiles. Before investing in an ETF, it would be beneficial to know their characteristics and what they bring to the table.

    Bond ETFs will allow you to receive income from the interest generated by the bonds that compose the fund. The risks are also more moderated, which makes bond ETFs recommended for short-term investing. 

    For longer-term investing, consider stock ETFs. Putting this kind of ETF in your portfolio will also potentially allow you to receive income from dividends. However, stock ETFs also have a larger risk to balance out the higher rewards – though the risk is usually less than individual stocks.

    Commodity ETFs bundle the securities for raw goods like gold and crude oil into one investment. When investing in a commodity fund, it’s essential to know whether you have ownership of the physical commodity or equity in companies that produce them. Depending on the answer, your tax implication and risk levels will vary.

    To further diversify your investments, consider international ETFs. These ETFs collect assets from countries outside the United States, granting you access to opportunities in developing and emerging markets. These funds can include investments in individual countries or a group of countries. Investing in these funds is a relatively easier and less-risky approach to investing in foreign countries.

    Sector ETFs allow you to invest in the 11 sectors in the US stock market. A sector ETF represents each sector, such as industrial, healthcare, or financial sectors. For investors tracking individual business cycles, this is a beneficial way to invest since they can see which sectors are performing well and adjust investments accordingly. Generally, the risk is increased compared to broad-market funds. 

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    Examples of ETFs On The Market

    • SPDR S&P 500 (SPY) is the oldest and most widely known ETF, tracking the S&P 500 Index.
    • SPDR Dow Jones Industrial Average (DIA) represents the 30 stocks tracked in the Dow Jones Industrial Average.
    • Invesco QQQ (QQQ) contains the Nasdaq 100, which is primarily comprised of technology stocks.
    • Sector ETFs index individual industries, for instance, oil (OIH), financial services (XLF), and energy (XLE).
    • Commodity ETFs contain commodity markets, such as crude oil (USO).
    • Physically-backed ETFs contain precious metals in the fund, such as the SPDR Gold Shares (GLD).

    Pros & Cons Of ETFs

    Pros

    • ETFs offer options for diversification. A given ETF can expose you to a group of equities and assets that you might not have considered before. 
    • An ETF’s liquidity allows it to be traded anytime you want. Just like a regular stock, ETF prices are updated throughout the trading day and you can buy and sell it at any time. This also allows you to look up the price changes easily using its ticker symbol.
    • Compared to a mutual fund, an ETF has lower fees. Since ETFs are not actively managed, you don’t need to pay as much for management, service, or most other fees associated with mutual funds.
    • An ETF is more tax-efficient. ETFs tend to net fewer capital gains than mutual funds, and thus are taxed less. There are also no tax charges incurred when an ETF buys or sells shares since it’s considered an in-kind redemption.
    • ETFs are generally sold at actual value. By being traded at a price close to their underlying securities, the price is kept as close to the actual value as possible.
    • ETFs are transparent. You can always look up the price activity of a fund and its holdings are disclosed to the public daily.

    Cons

    • While ETFs offer many opportunities to diversify, some ETFs are less diverse. In some sectors or foreign stocks, you might have fewer choices in equities.
    • Compared to dividend-paying stocks, ETFs usually pay out lower dividends. However, this is balanced out by the lower risk of owning ETFs.
    • Costs associated with ETFs could be higher if you compare it to a regular stock. While still lower than an actively managed mutual fund, an ETF does still ask for management fees.
    • Selling ETFs can be hard if the particular fund isn’t traded frequently. 
    • If a fund hasn’t brought in enough assets to cover administration costs, an ETF can close. This means investors have to sell sooner – likely at a loss. 

    Is An ETF Right For Me?

    Like any other investment, whether or not an exchange-traded fund is right for you will depend on your personal circumstances and other considerations. First of all, it’s essential to know what you want out of investing in exchange-traded funds. Are you looking to pay for a big expense in the short term or are you looking to make income out of investing when you retire? These things will influence your investment approach. 

    When considering investment approaches, one of the most important things to think about is time. Your approach to investing if you’re looking for short-term gains will differ from your approach if you’re looking for long-term gains. ETFs can be used in either approach, but generally, an ETF is most effective for those looking for long-term investments. 

    Another thing to think about is your risk tolerance. Your risk tolerance consists of your personal attitude toward risk as well as the level of risk you can afford. ETFs aren’t inherently aggressive or conservative investments. That said, if you’re rather risk-averse, there are other investment methods that can more reliably generate returns than ETFs.

    If you’re open to investing in global markets, ETFs can provide that option for you. While there are ETFs that track US indices, it’s generally more effective to use other avenues for domestic investing.

    How To Pick The Right ETF

    There are numerous ETFs on the market for you to choose from. With more than 2000 choices listed on US exchanges, determining which ETF is worth your investment does get challenging. That’s why there are some considerations involved if you’re looking to invest in an ETF. 

    One of the most important things in an ETF is its underlying index. As ETF indices track different things, you need to consider how you’re going to allocate your assets. Does the ETF you’re looking at match the asset allocation you have in mind? 

    Another thing to ensure is that the fund is reasonably priced and tradable. Here, you can start with the fund’s expense ratio. The expense ratio on ETFs represents the annual management fees and operating costs of the fund. This information usually can be found on the prospectus of each fund and also on financial websites. For ETFs, the typical expense ratio is about 0.2% but it can go as low as 0.02% in some cases. 

    The ETF’s liquidity also plays an important role when investing in exchange-traded funds. The main contributing factors of an ETF’s liquidity are the liquidity of the fund itself as well as its underlying shares. If a fund is traded at larger volumes daily and has more assets under its management, they’re generally more liquid. For instance, an exchange-traded fund investing in S&P 500 stocks would likely be more liquid than an ETF investing in alternative energy companies.   

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    Tips For Effective ETF Investing

    • Know what assets you want to invest in. Do you want to spread your investments widely across several types of assets, or put your money in a certain kind of industry? This will depend on your objectives and what markets you’re aiming to invest in. 
    • Also, consider the geographic element of an ETF. Some funds allow you to invest in assets from different countries and regions, some others capture assets in domestic markets. 
    • Always keep the net asset value of an ETF in mind. The NAV estimates an ETF’s fair value so you can decide to buy or sell the fund based on the offers available.
    • To anticipate market volatility and sudden ETF price movements, keep up-to-date with market news. ETF prices usually move in response to news and economic reports from companies. It may be best to avoid trading ETFs on days with wild price swings.
    • Don’t place orders near the market’s open or close. These times are the most volatile hours for ETFs and prices may vary wildly from its NAV. 
    •  If you’re about to buy or sell ETFs that contain international stocks, pay attention to the time their respective markets open. Knowing when foreign markets open and close will help you get better prices on your ETFs. 
    • If you buy and sell ETFs too often, the trading costs can add up. Avoid needless trading and if possible, find a broker that offers commission rates.
    • To ensure ETF liquidity, choose funds with good trading volume. It’s not a guarantee of liquidity, but it has a better chance for your orders to be fulfilled quicker. 
    • If you’re a passive investor, stick to well-known indices. The S&P SmallCap and the S&P 500 indices, for instance, are good choices for hands-off investors. 

    Conclusion

    With its flexibility in transactions and its ability to simplify diversification of assets, the popularity of exchange-traded funds is well-earned. Investors can more easily buy or sell them while still being able to invest in various assets.

    If you’re looking to invest in ETFs but don’t know where to start, reach out to Wesley Mortgage, LLC! Our team of professionals will be happy to help advise you on your ETF investments.

    Written By Ed Wallace
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