ETFs: Exchange-traded Funds - What is ETF And How Does it Work?

“ETFs are exactly what their name suggests—funds that trade on an exchange just like stocks. As with regular mutual funds, ETFs own baskets of stocks, bonds or other holdings… ETFs offer distinctive differences that set them apart from mutual funds, particularly in terms of tax-efficiency, costs, and transparency about their holdings.”

ETFs, stocks, bonds, mutual funds, and other securities provide investors with a wide range of investment options. Perhaps you have considered making a few investments, but still yet to decide which one works better for you, here’s a good place to take a pause. We’d try to cover all the important details about ETF—what is an ETF? How do ETFs work? How to buy and sell ETFs, Pros and Cons, and other necessary details.

What is an ETF?

Exchange-traded Funds (ETFs) are a type of securities closely comparable to index funds, only that they can be traded at any time of the day just like stocks and purchased on margin, and often track an underlying index. According to Wikipedia an ETF “is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep its trading close to its net asset value, although deviations can occasionally occur.” Simply put, an ETF is a basket of securities that can contain assets like stocks, bonds, and other valuable commodities that can be bought or sold through a broker. The first ETF was launched in 1993 as the Standard and Poor’s Deposit Receipt—SPDR or Spider. By purchasing the SPDR or Spider investors were able to imitate the S&P 500 performance having to buy an actual index fund. The SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index. ETFs that track index performance is likely to get more dividend payments or reinvestments for the stocks in the index.

ETFs, provide investors with a more convenient way of investing such that investors can purchase a number of securities in a single transaction. It is like merging the benefits of stock with that of a mutual fund. Since the emergence of mutual funds the next big thing was the ETF as it has since provided investors minimal cost benchmark returns. Another interesting thing about ETFs is that they sometimes trade with no commissions. 

How do ETFs work?

ETFs, offer investors the opportunity of buying and selling a basket of securities at a low cost rather than buying them individually which may attract higher charges. Unlike stock where investors have the opportunity of directly purchasing shares, ETFs do not allow investors to purchase shares directly, rather, large blocks of at least 50,000 shares known as ‘creation units’ are being issued to investors by the ETF’s sponsor. Afterward, the units are then purchased by an authorized participant such as an institutional investor or a market maker who places them in a trust. Once the creation units have been duly purchased and placed in a trust, the units are then split into ETF shares by the authorized participant before selling them to investors on a secondary market. Therefore, purchasing an ETF on a secondary market basically means that the investor is investing solely in the performance of an underlying security or bundles of securities.

The prices of ETFs are bound to change depending on the frequency at which they are bought and sold. They can either trade at the premium or discount of their original costs which is usually a marketable cost that allows easy trading. 

Types of ETFs

ETFs provide investors with several options such as price increase, income generation, offset a risk, and speculation, thereby, diversifying and building an investor’s portfolio. There are several types of ETFs available to investors and they are as listed:

• Bonds ETFs: Bond ETFs invest in multiple fixed-income securities such as corporate bonds, government bonds, and municipal bonds. They are liquid, transparent, and can be traded on secondary markets, unlike regular bonds which are fixed-income assets and not liquid. The liquidity of bonds ETFs makes it possible for them to be traded on an exchange. The basic idea behind bond ETFs is the mimicking of a similar index or underlying asset. Though bonds ETFs do not hold the benefit of having tax advantages like traditional ETFs, it, however, supports a monthly dividend pay-out with interest.

• Currency ETFs: The goal of the currency ETFs is to give an investment exposure to foreign exchange (forex). They allow investors to invest in multiple foreign currencies such as Euros, Pounds, Rupees, or the Canadian dollar. This type of ETF is mostly passively managed with an underlying currency holding in a particular country or basket of countries. It extends portfolio diversification beyond international borders. Currency ETFs track correlating value of a currency or basket of currencies on the foreign exchange. They are good for portfolio diversification, speculation on forex markets, and hedging currency risks. They also allow low-cost investors to gain access to the forex market via a managed fund without having to concern themselves with the responsibility of placing individual trades. 

• Commodity ETFs: Investment made in the commodity ETFs are usually hard commodities such as natural resources, precious metals, precious stones, or agricultural produce. The commodity ETF tracks the performance of the commodity index, and they are made up of futures or asset-backed contracts responsible for tracking a particular group of commodities, or commodities. Investing in a commodity ETF does not imply that an investor has access to hard commodities or won physical assets, rather the investor owns a set of contracts backed by the commodity. This type of ETF is very beneficial to the investor because the investors do not need to concern themselves with the fundamentals of purchasing futures or other derivatives products.

• Industry ETFs: An Industry is created to track the performance of an industry index such as the banking, technology or oil and gas sector. Its function is to mimic the performance of a similar industry index without having to outperform it. 

• Inverse ETFs: The inverse ETF is also referred to as a Short ETF or Bear ETF. It is created by using different derivatives to profit from the value decrease of an underlying index. Inverse ETFs also involve borrowing and selling securities in the hope to repurchase them at a lower price just like holding various short positions. Shorting is the process of selling stock in hope that the value would decline, and then, repurchasing it at a lower price. Inverse ETFs are more likely to attract higher fees compared to traditional ETFs.

Important Things to Note Before Buying and ETF

Though the idea of buying ETFs may seem straight-forward as it is when buying stock or equity, it is still important to make further inquiries or research about how they work and put into further consideration if you the type of seurities you included in your portfolio. These considerations are as follows;

Investment Strategy: Every investment has particular strategies that work well with it, and every investor has custom strategies that work best in selected investment vehicles. Having an investment strategy may require that you clearly define your interest in ETF and why you want to invest in it. 

Investment Limit: After determining why you want to invest in an ETF and outlining the investment strategies you would be using the next thing to consider is the investment limit. For how long do you intend holding the ETF? Are you more of the long –term or short-term investor?

Portfolio Diversification: ETFs allow you to invest in multiple assets at the same time. Therefore, it is best to carefully research and select the various assets you would like to invest in. Note that, it is simply not enough to select attractive ETFs, rather, it is best to select assets that correlated to your portfolio.  The benefit of having a broad variety of investments is to help investors diversify portfolio risk or hedge risk. For example, with an International ETF, you can broaden and diversify your portfolio with multi-national stock holdings. 

Cost, Commissions, and Fees: ETFs are cost-effective as most ETFs tend to have low fees and are likely to “track an index with a low amount of tracking error.” Low tracking an index gives enables the ETF to stay on track so as not to under-perform the correlated index or over-perform it. Often times, ETFs are commission-free or low-cost, yet, some ETFs that are close-ended carry extra charges—management fees. The costs and fees of ETFs may differ according to assets, some lower and others higher. It would be, therefore, wise to make all calculations with the appropriate costs before buying an ETF. When it comes to ETF trading fees, usually, commissions are charged per basket.

Tax Implications: Some securities like IRA and 401(k) have tax benefits others do not. However, ETFs based in the U.S. hold tax benefits while foreign-based ETFs do not have tax benefits within the U.S. ETF tax implications come about in two ways; either through a tax on a gain gotten from an ETF trade or sale or through a capital gain gotten from the fund distribution. ETFs capital gains distribution is not as frequent as that of mutual funds.

Benefits of ETFs

Liquidity: Unlike mutual funds that are only traded once a day at the close of the market ETFs trade all day—can be bought or sold at any time of the day. Some ETF shares average trading volumes are in hundreds of thousands while others are in millions of shares per day this makes ETFs highly liquid. 

Transparency: The price activity and history of the ETF on an exchange are accessible by all with an active internet plan. The daily funds holdings are released at the end of each day for investors to go through compared to mutual funds which are either released monthly or quarterly.

 Diversification: ETFs not only allow investors to diversify their investments across a broad market—stocks, bonds, and other securities—but it also allows investors to diversify their investments across industries. Individually buying investment securities to include in a portfolio may take time and cost more, but buying ETF baskets gives you a one-off opportunity at a lower cost. 

Low-cost: ETFs are well known for their relatively low costs, fees, and commission-free services. They have no front-end or back-end loads attached to them. Though some ETFs are actively managed and attract extra fees on management, still, most ETFs are not actively managed and they have minimal expense ratios which makes them even more affordable compared to other investment assets. ETFs can also be purchased by low-cost investors at an affordable minimum investment amount which differs by the various ETF providers.

Tax-advantages: ETFs tax liability is not affected by the buying and selling of ETF shares on the open market compared to mutual funds which are likely to attract capital gain taxes which affects all shareholders due to managers selling off portfolio assets to meet up with redemptions. On the contrary, ETF redemption involves paying investors their shares in stock instead of cash, thereby, reducing the tax liability on an ETF. Another perk of this is that investors who redeem their ETF shares are paid with a cost-effective method—the lowest cost basis available that way the ETF capital gains exposure is reduced.

Pros

• Low cost, fees, and commissions

• Supports risk management through portfolio diversification

• Supports multiple investments

• Helps investors penetrate strict/difficult investment niches

Cons

• Extra charges on actively-managed ETFs

• Difficulty in unloading ETFs that are not frequently traded

• Shuttered ETFs

How to buy and sell ETFs

ETFs are best for investors who like to hedge their risk, invest in foreign sectors, and paly the market. To buy an ETF you would have to bid an amount or take out an offering price. When looking for ETFs to buy it is important to note that in as much as ETFs are cheaper to buy, their funds can still vary from fund to fund. Another thing to note that may slightly affect the costs of ETFs is the index tracking costs. These ETF providers vary in their costs mostly as a result of high demand and complexity that is why it has been repeatedly stated that ETF costs are relatively inexpensive. 

ETFs are easy to buy and trade, and the first step to buying ETFs is opening a discount brokerage account. That is trading through traditional broker-dealers or online brokers. Other options available are Robo-advisors such as Wealthfront and Betterment which not only provides investors with ETF services but also financial advice on investments and portfolio diversification. Before buying, it is best to consider the type of ETF that best fits your portfolio. When it comes to selling ETF shares most ETF investors sell their ETF shares on the open market to liquidate their holdings.

ETFs Vs Mutual Funds

Exchange-traded Funds and Mutual Funds have quite some similarities in the case of allowing investors access to different commodities which promote diversification, however, there are still underlying differences between both funds. The first obvious difference between ETFs and a mutual fund can be found in the fees. ETFs fees are relatively lower than mutual funds. The regular expense ratio for an average equity mutual fund in the U.S is 1.42% per annum compared to the equity ETF expense ratio which is at 0.53% per annum. Mutual funds certainly have benefits that out-do the ETF, but when it comes to tax implications they are nowhere compared to ETFs. Due to the actively-managed nature of mutual funds, they are bound to attract capital gains on the buying and selling. For example, when an investor decides to sell a mutual fund, the fund manager would first have to sell some securities to raise cash which in turn attracts capital gains. On the other hand, since most ETFs are passively-managed they do not always incur extra charges and capital gains. In 2018, U.S investors had invested a total of $3.4 trillion in ETFs doubling the amount of 2013 this statistic is in comparison to the report given by the Investment Company Institute where it has been reportedly stated that as of December 2018 there were 8,059 mutual funds with a total of $17.71 trillion assets under management. Despite the popularity of mutual funds, investors have still poured a lot of funds into ETFs because of their easy access, simplicity, portfolio diversifications, and relatively cheap services.

Key points

• ETFs trade daily on an exchange just like stocks and their prices fluctuate as ETF trades go on 

• Investors can only purchase ETF shares through authorized participants on a secondary market

• ETFs provide investors access to broad segments of the market or impenetrable niches, depending on what type of ETF the investor chooses

• ETFs allow for multiple investments such as stocks, bonds, and other commodities of which some are geographically restricted and the others multi-national. The multiple assets found within an ETF usually gives room for diversification.

• ETFs are often commission-free and offer low expense ratios. Brokerage commissions are still charged per transaction made.