An exchange traded fund or ETF is an investment vehicle that comprises a group of stocks or other asset classes like bonds and commodities, and can be traded on an exchange just like a common stock. Unlike mutual funds that can be bought or sold only after the stock markets close, ETFs can be traded throughout the regular trading hours and in the extending trading session.
An ETF is a financial vehicle that tracks indices or a unique portfolio of stocks in different sectors. ETFs are usually managed independently and maximize their efficiency over time.
Types of ETFs
There are several categories of ETFs based on the underlying asset class and different types of investment strategies. Some of the types of ETFs are:
Index ETFs
These ETFs track or replicate the holdings of a benchmark index like the S&P 500 Index or Dow Jones Industrial Average. Both Index ETFs and Index Funds or Index mutual funds track a market index like the S&P 500 and come under the passive investing style. The difference between them is that Index ETFs can be traded like a regular stock while Index Funds can be bought or sold only after markets close. Also, Index ETFs do not have a minimum investment value condition and are more tax efficient.
Examples of Index ETFs include SPDR S&P 500 ETF (SPY) and Fidelity Nasdaq Composite Index (ONEQ).
Sector and industry ETFs
These ETFs invest in a particular sector or industry such as pharma, tech, energy, and consumer. Examples of sector ETFs are Consumer Staples Select Sector SPDR ETF (XLP) and Vanguard Information Technology ETF (VGT).
Commodity ETFs
Commodity ETFs provide investors exposure to commodities like gold, silver, oil, natural gas, and agricultural goods. SPDR Gold Trust (GLD), iShares Silver Trust (SLV), and United States Oil ETF (USO) are examples of commodity ETFs.
Currency ETFs
Through currency ETFs, investors can gain exposure to a single currency or a basket of currencies. These ETFs can help in hedging exchange rate risk. Examples include Invesco Currency Shares British Pound Sterling Trust (FXB) and WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU).
Inverse ETFs
Also called a Short or Bear ETF, an Inverse ETF is created using derivative contracts (such as futures) to gain from a decline in the value of an underlying index. Investing in inverse ETFs is often compared to holding short positions in securities, which involves borrowing securities and selling them with the intent of repurchasing them at a lower price. Examples of Inverse ETFs are Direxion Daily Small Cap Bear 3X Shares (TZA) and ProShares Short Russell 2000 (RWM).
Style ETFs
Some ETFs follow a particular approach of investing like value or growth investing. Certain ETFs combine style with the size or market capitalization (large-cap, mid-cap, and small-cap). Examples include Schwab U.S. Large-Cap Value ETF (SCHV), Vanguard Small-Cap ETF (VB), and Vanguard Small-Cap Growth ETF (VBK).
Aside from the aforementioned categories, there are several thematic ETFs like the First Trust Cloud Computing ETF (SKYY) and iShares Global Clean Energy ETF (ICLN).
How ETF work?
ETFs provide investors exposure to a portfolio of desired assets instead of individually buying multiple assets and managing them. Once the ETF sponsor or issuer decides to create a new ETF, it enters into contractual relationships with one or more authorized participants (financial institutions which are typically large brokers-dealers) and issues the ETF shares to the authorized participant in exchange for the underlying securities (stocks in case of equity ETFs). When the authorized participant receives a block of ETF shares (the block is called a creation unit), it can sell them to individual investors, institutional investors, or market makers on the stock exchange (secondary market).
In the case of redemption, individual investors generally sell their ETF shares in the open market. Institutional investors can also offload their ETF shares in the open market or in case of a large number of ETF shares (such that a creation unit can be formed) they can sell it to the authorized participant, who will deliver the creation unit to the ETF issuer and receive the underlying securities in exchange.
Thus, authorized participants help in maintaining the liquidity of the ETF through the creation and redemption mechanism. They purchase and redeem shares directly from the ETF in large blocks called creation units to maintain the supply and demand of the ETF.
What are the Pros and Cons of ETFs?
Pros
Diversification: ETFs provide exposure to a range of equities, asset classes, and investing styles, thus providing the benefits of diversification to the investor.
Stock-like features: ETFs can be traded like equities and provide the benefit of liquidity to investors. Like equities, ETFs can be purchased on margin, sold short and we can also trade derivatives like futures and options in ETFs.
Lower expense ratio: ETFs generally have a lower expense ratio than mutual funds as they are mostly passively managed.
Low minimum investment: One can start investing in ETFs by purchasing just one ETF share.
Tax advantages: ETFs are considered one of the most tax-efficient investment vehicles. They generally incur lower capital gains tax than mutual funds due to comparatively lower turnover and also because of the creation and redemption mechanism between the ETF issuer and authorized participants.
Transparency: ETFs disclose their holdings/constituents every day compared to mutual funds, which generally disclose the list of their holdings on a quarterly basis (some choose to disclose on a monthly basis).
Cons
Trading costs: The costs for trading ETFs can outweigh the savings in the form of a lower expense ratio and tax efficiency, especially if the investor is frequently trading ETFs.
Liquidity risk for thinly traded ETFs: In case of thinly traded ETFs, the investor might find it difficult to sell his investment. It is prudent to check the liquidity of an ETF by assessing the spread between the bid and ask prices and the trading volumes. ETFs with lower liquidity have higher spreads.
Tracking error: ETFs that replicate an index are subject to tracking error, which indicates the difference in an ETF’s return and the return on the benchmark index (It is computed as the standard deviation of the difference between the return on an ETF and its benchmark). A large tracking error reflects poor performance of the fund. Tracking error can be caused by many factors including trading and fund management fees, which tend to reduce an ETF’s return.
Factors to consider before investing in ETFs
The market is flooded with a wide range of ETFs. So how does an investor select the right ETF? Firstly, the investor should select an ETF with the underlying asset/index to which he seeks to gain exposure based on his investment objective. Check the ETF’s constituents to know the level of diversification that the ETF offers.
Another important parameter to assess is the liquidity of the ETF. For instance, as per the TipRanks database, the average daily volume for the Consumer Staples Select Sector SPDR ETF (XLP) is 8.91 million (as of Dec 18), while that of the Energy Select Sector SPDR ETF (XLE) is 30.8 million, thus indicating that the XLE ETF has higher liquidity than XLP ETF. Generally, ETFs with higher assets under management have higher trading volumes, are more liquid, carry a tighter bid-ask spread, and lower expense ratio.
Commissions, fees, expense ratio, and tracking error of the ETF are other factors that should be considered before investing in ETFs.
Mutual Fund VS ETFs
Unlike mutual fund shares, ETFs trade like stocks and are not priced according to their net asset value at the end of every day. For this reason, it is actually possible for an ETF to trade at a higher or lower price than its underlying assets. Because traders take advantage of any open arbitrage opportunity (by buying the ETF and selling the underlying portfolio), the difference between the market price and fair value is usually very small.
Some ETFs offer different types of leveraged investment. A 2x ETF would offer twice the return of any movement in the price of its underlying asset’s movement. For example, if you invested in a 3x gold ETF your return on a 1% price increase in gold would be 3%; however, this also increases your risk by a factor of 3. Inverse ETFs are a way to bet against the movement and offer a return based on a decline in value. For example, the Short S&P 500 (SH) would make a 1% gain if the S&P500 experiences a 1% decline.
You can use ETFs to invest in markets that are hard to penetrate as a private investor. For example, it is very difficult to invest in the Chinese market efficiently as an outsider; however, by buying a US-based Chinese market ETF you can easily expose your portfolio to that market, sidestepping all the hassle of doing so directly.
TipRanks offers extensive information about each ETF and analyzes the current sentiment by Wall Street analysts, financial bloggers, corporate insiders, and hedge funds.
Conclusion
ETFs are an efficient way of investing in different stocks or asset classes instead of individually purchasing them. They are easy to trade and investors with small capital can also invest in ETFs and gain from diversification. However, as discussed above there are certain factors, like liquidity, that investors should consider before making an investment in ETFs.
FAQ
How ETF Price is Determined?
The price of the ETF is calculated by the sum of the assets in the fund, securities and cash, fewer liabilities, and their distribution in the number of outstanding shares. This data is given daily so the price of the ETF can be calculated in real-time.
Which ETF To Buy For 2021
ETFs are divided into Indices, sectors, commodities, currencies, and more. Therefore there is no one right answer as to the best ETF. In each sector or index, there are several relevant ETFs, so it is important to examine the performance of the ETF before you buy.
Is ETF Safe?
Investing in ETFs is usually safer than investing in specific stocks because in most cases the ETFs are indexed and contain a diverse investment portfolio. ETFs also reflect market volatility and the general trend of the market is bullish
Is It Possible To Trade-In An ETF Throughout The Day?
ETFs can be traded throughout the day. There are no restrictions on the quantity and frequency of buying and selling ETFs