A Beginner’s Guide to Understanding ETFs

Key Points

• ETFs encompasses multiple investment vehicles such as stocks, bonds, commodities or a combination of all in a single basket

• It offers both the trading benefits of stocks and diversification benefits of mutual funds

• It has tax benefits

• It has low-cost benefits

What is an ETF?

An exchange-traded fund (ETF) is a basket of securities made up of stocks, bonds, commodities, or a combination of all, that can be bought or sold through a broker. ETF is an acronym which stands for exchange-traded fund. It is an investment fund that is traded on stock exchanges just like stocks, bonds, and other commodities. It is also known for its ability to combine the valuation feature of a mutual fund which makes it possible for it to be bought or sold for its net asset value at the end of each trading day. It also combines the tradability feature of a closed-end fund which allows it to trade throughout a trading day at prices that may be more than or less than its net asset value.

Understanding the basics of ETFs

ETFs are traded by distributors who only trade ETFs directly with authorized participants, unlike stocks that can be traded from investor to investor. There are also other investors who trade ETFs shares on the secondary market through a retail broker. These authorized participants, most times, include large broker-dealers the distributors have an agreement with. The authorized participants or fund providers that own the underlying assets, design a fund to track their performance then sell the shares in that particular fund to investors. They also act as market makers on the open market, being able to exchange creation units with underlying securities they own to provide liquidity of ETF shares. This helps ensure that the net asset value of the underlying assets estimates their intraday market price.

ETFs, provide investors with the benefit of trading daily like stocks on the stock exchange and the diversification benefits of mutual funds. It combines the best features of both investment vehicles. ETFs make it possible for traders or investors to buy and sell a basket of assets rather than buy them individually. They are designed to track the value of an underlying asset like the S&P 500, and they are also traded at market determined prices that differ from the asset.

ETFs can be traded on stock exchanges just like stocks and also have their own tickers which let speculators identify and track their price movement. An ETF focused on stocks called the SPY tracks the S&P 500 while others like HACK track a cyber-security fund and FONE, which tracks an ETF for smartphones.

ETFs are usually trade close to a net asset value such that they track indexes. Some ETFs either track a stock index or a bond index. Many investors find ETFs appealing because they are low-cost and tax-efficient investments. ETFs were first initiated in the United States in 1993 and in Europe by 1999. They were initially known to be index funds until 2008 when the US Securities and Exchange Commission (SEC) started authorizing the creation of actively managed ETFs.

Actively Managed ETFs

Here, traditional brokers or online brokers that act as portfolio managers are actively involved in buying and selling companies’ shares and changing the holdings within a fund. This type of fund management attracts a higher expense ratio compared to passively-managed ETFs. At the end of the day, the cost an investor is subject to would depend on what type of fund management they choose.

Types of ETFs

• Index ETFs: Most ETFs fall under the category of index funds as they imitate the performance of a specific index.

• Stocks ETFs: ETFs in this category tracks the performance of stocks, either large-cap or small-cap. It also considers the growth and value of these stocks.

• Bond ETFs: this includes corporate bonds, government bonds, municipal bonds (state and local bonds)

• Commodity ETFs: concerns commodity investments such as gold or crude oil

• Currency ETFs: concerns foreign currencies investment such as EUR, GBP, or CAD.

Examples of ETFs

• The SPDR S&P 500 (SPY) which tracks the S&P 500 Index

• SPDR Dow Jones Industrial Average (DIA) which represents the 30 stocks in the Dow Jones Industrial Average

• Invesco QQQ (QQQ) which indexes the Nasdaq 100

• iShares Russell 2000 (IWM) which tracks that Russell 2000 small-cap index

ETFs Vs Mutual Funds

In many ways, ETFs are quite similar to mutual funds except that ETF shares can be bought and sold throughout a trading day just like stocks. Another distinguishing feature is that ETFs don’t sell or redeem their individual shares at net asset value (NAV) like traditional mutual funds. Rather, shares of ETFs are purchased or redeemed by financial institutions directly from the ETF in large blocks of 50,000 shares or more. These large blocks are called ‘creation units.’

Unlike mutual funds, ETFs have relatively lower costs (a lower expense ratio); relatively low because some index mutual funds have low expense ratios and some ETFs have high expense ratios. However, most of the time ETFs by far have lower expense ratios compared to mutual funds. In the US, equity mutual fund charges an average of 1.42% annually in its administrative expenses. While the fees on equity ETF are 0.53% on the average. Another reason why ETF expense ratios are relatively low is that they track an index. For example, there is a possibility for an ETF that tracks the S&P 500 to contain all 500 stocks in the S&P, thereby, making it a passively-managed fund. Nevertheless, not all ETFs are passively-managed funds.  

ETFs are also tax-effective, hence, more attractive to investors compared to mutual funds. Mutual funds may generate more returns and other capital gains compared to ETFs, however, it also incurs more taxes for the trader or investors. For example, in the US, whenever a mutual fund realizes a capital gain that does not balance a realized loss, the mutual fund would have to distribute the capital gains to its shareholders. There is a tax on every capital gain distributed to each shareholder whether or not they reinvest the distributions in more shares. Contrary to this, ETF holders can sell their ETF shares on the stock market rather than incur a taxable redemption through distributions like mutual funds. By selling their ETF shares directly on the stock market, the investors would only realize capital gains when they sell their own shares.

Another important distinction between ETFs and mutual funds is that, while mutual funds are only bought or sold at the end of a day’s trading, ETFs can be traded throughout the trading day, as long as the market is open. Investors can execute the same trades that they do with stocks since ETFs are traded on the stock exchange. They can sell short, buy on margin, or even use a limit order.

How to Invest in ETFs

There are different approaches to investing in ETFs; it all boils down to individual preference. Investors can either invest in ETFs by accepting standard offerings made by online brokers. These offerings differ by the brokers as different fees or charges may apply. There’s also the option of robo-advisors like Wealthfront and Betterment which help investors create portfolios out of low-cost ETFs. However, trading ETFs requires the involvement of traditional broker-dealers and online brokers.

Advantages and Disadvantages of ETFs

ETFs, like every other investment vehicle has its advantages and disadvantages. Many investors greatly consider ETF investments because of their relatively less expenses and diversified features. In 2018, US investors invested approximately $3.4 trillion in ETFs, and have continued to believe in the capability of ETFs to perform even better in the coming years.

Advantages

• Open to all. The openness and transparency of ETFs is one key feature that attracts investors. Virtually anyone with good internet access can access the price activity for any ETF on an exchange. Furthermore, at the end of each day funds’ holdings are made available to the public.

• Diversification. ETFs are comprised of a basket of securities that allow investors to either diversify across different companies or industries or securities. It helps investors afford all these different securities and commodities at a less expensive price compared to if the investors were buying them individually.

• Low costs. Asides the diversification benefits that come with owning a basket of securities, ETFs make it less expensive for investors to be able to afford multiple securities or commodities rather than buying them individually which would cost more. Also, when it comes to buying and selling ETFs, investors or traders require only one transaction to buy and one transaction to sell, as a result of that, fewer brokerage commissions would be involved.

• Tax benefits. Unlike mutual funds, ETF investors are only taxed when they decide to sell the investment.

Disadvantages

• Fees and Commissions: Although many brokerages have dropped their ETF commissions to $0, it doesn’t change the fact that other brokerages wouldn’t still charge commissions. The trading costs vary by the brokerages and some may be relatively high compared to the general notion of ETF low costs.

• Getting Buyers: Depending on the current market prices when an investor is ready to sell, getting buyers may be quite difficult. Also, ETFs that are not frequently traded may also develop the tendency of getting difficult to unload.

• Loss Risks: It is possible that a fund gets to the point where it is unable to bring in enough assets to cover administrative costs. If this happens in an ETF, investors may need to sell earlier than they had planned, most times at a loss.

ETFs may be very attractive to investors, however, like other investments it comes with a price. The major thing to pay attention to in ETFs is the costs involved. Though relatively lower, ETF costs also differ from fund to fund depending on the issuer.