What is an ETF?
An ETF which stands for Exchange-traded fund, (Figure 1) is a mix between a regular stock and a mutual fund. To explain this further, imagine the flexibility of trading a regular stock combined with the diversification previously found only within mutual funds.
An ETF is a fund that trades on an exchange just like any other listed stock and can be bought or sold with complete ease and throughout the trading day. ETFs have grown tremendously over the past 20 years and have several advantages associated with them, not to mention the wide range of available funds that investors can choose from. Nonetheless, they remain a financial product with varying levels of risk.
Figure 1 - Daily DIV ETF chart
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How do ETFs work?
It’s fairly simple and straightforward. A fund provider owns different underlying assets that usually track a specific index or group of products and sells shares to investors. Technically speaking, investors do not own the underlying assets in the fund and instead, own a portion of the ETF. Regardless, they will still receive dividends and are part of other corporate actions indirectly.
The beauty of ETFs is that they can be customized to include anything. For example, there exist funds that track precious metals or the stocks of the S&P 500 and even hybrid funds that are multi-asset.
ETFs trade at a market-determined price that is usually different from the price of the underlying asset or basket. Also, the long-term performance of an ETF may vary from the index or group of assets it tracks because of associated expenses and other factors.
ETFs versus Mutual Funds
The most obvious difference between ETFs and Mutual Funds is the relatively lower expenses associated with ETFs. The average fees on an equity mutual fund for 2019 amount to around 0.52% versus 0.18% for an equity index ETF. This is largely due to the fact that Mutual Funds tend to be actively managed while ETFs are passive although it’s not a rule.
Also, ETFs are more tax-efficient for investors than mutual funds as the latter exhibits more turnover especially for the ones that are actively managed.
Despite their growing popularity, ETFs are less in number than mutual funds and both products offer something for different types of investors.
ETFs versus Stocks
ETFs are very similar to stocks in the sense that both trade on a centralized exchange and have their own ticker symbols. The difference lies in the amount of customization that fund providers are able to accomplish on ETFs. A stock represents one company while an ETF can go as far as having thousands of stocks as underlying assets within the fund. Furthermore, ETFs can be multi-asset which includes even more diversification options for investors.
Looking at the mechanism behind ETFs, it’s clear that ETFs are products created for investors who do not have the time to analyze individual stocks and assets nor are interested in creating a diversified portfolio from scratch and adding every single asset to it. Traditional portfolio building can be daunting and hectic to establish and maintain and this is where ETFs come in. They make it easy for anyone to create a highly diversified portfolio of holdings from just a few ETFs.
ETFs (Figure 2) can be focused on a specific sector, group of commodities, global stocks, corporate bonds, utilities in Europe, technology stocks in Japan, Clean energy and the list goes on with hundreds and even thousands of variations that are available.
Figure 2- Daily DIV ETF versus Coca Cola Stock (Ticker: KO)
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ETFs advantages and disadvantages
During 2020, US-listed ETFs experienced an inflow in excess of $500 billion, up from around 50% during 2019. This shows the recent trend in how investors are flocking towards simpler products that offer broad diversification.
Advantages
Diversification
One of the main and attractive aspects of ETFs is their simplicity and ease in offering a diversified approach to investing. ETFs allow diversification across different assets such as bonds and stocks while also offering access across different industries and sectors. The options are countless and with just a few ETFs, an investor can create a highly diversified portfolio that could go as far as covering thousands of underlying assets within each fund.
Transparency
Information on ETFs is present online across major financial news websites as well as the fund provider’s website. Anyone with access to the internet can search for news, pricing, holdings, and other information pertaining to a specific ETF. Mutual Funds are a bit more discreet in terms of revealing information specific to the fund i.e. disclosing holdings monthly or quarterly instead of real-time which is the case for ETFs.
Taxes
Investors usually pay taxes only when they sell their ETF while for mutual funds, the need to sell assets to raise cash can include a heavier tax load.
Disadvantages
Costs
While expense ratios are one thing, the need to pay commissions when trading through an online provider creates another layer of expenses that could affect the overall performance of an investor's portfolio. Nonetheless, most brokers have greatly reduced commissions while others have removed it completely or in favor of a different expense model that is still seen as advantageous for investors.
Liquidity
This is an important point to discuss as not all ETFs experience the same money flow or interest from investors. While some funds trade heavily throughout the day, other ETFs may not exhibit the same daily liquidity and could be harder to buy or sell at a certain desired price. Some ETFs may include one or more assets that are deemed desirable to investors while other ETFs may not be as popular.
Closure
Some ETFs may face strong money outflows which render the fund unable to cover costs. In this case, the fund is likely to close with investors forced to sell at an undesirable time and price. This is not uncommon and a fund may be invested in assets that have recently faced a sharp price decline, forcing investors to exit their positions.
The right ETF for your portfolio
If you’re looking for the simplest approach to investing in a broad range of stocks, certain index ETFs may be right for you. If you’re an investor who believes that energy prices are likely to go up over time, there exist Energy ETFs that track a variety of such products. If you’re someone looking to be invested across a broad spectrum of asset classes, you will find plenty of ETFs that are multi-asset or simply invest in a few top-performing ETFs where each one tracks a certain asset class.
At the end of the day, it depends on your expectations, investment goals, and risk tolerance as well as how much time and effort you are willing to personally invest in creating the right portfolio. Some people do not have the time for this and prefer owning one broad ETF or a few while others may be invested in dozens of ETFs for ultimate diversification.
On a different note, some investors believe in the actively managed approach of mutual funds who are always attempting to outperform the market and sometimes, with good success. This is a good option for the more risk-tolerant investor who wants to try their luck at making bigger returns if they believe a certain fund manager is capable enough.
How to invest in ETFs
Nowadays, opening a trading account is as easy as filling out a form, submitting verification documents, and funding your account, a process that takes no more than two or three days. For ETFs, it’s no different. You would need to open an account with a trading provider that offers ETFs such as CFI.
The best providers to look for are ones with experience, a good name in the industry, dedicated client support, low or zero commissions, and a provider who would go the length to make sure your trading experience is the best it can be.
The five major types of ETFss
The below categories are not the only ones available but are seen as the most sought-after types of funds.
Stock ETFs
Stock ETFs include groups of stocks such as large-cap companies, small-cap companies, highest dividend-paying companies, and hybrids of stock categories. They are great options for investors looking to hold a wide range of stocks and across different sectors and markets.
Commodity ETFs
Commodity ETFs may be directly invested in broad baskets of commodities which could include Gold, Crude Oil, Coffee, Cocoa, and others while certain commodity ETFs may be invested in a specific category of commodities such as agricultural products. A stock inclined commodity ETF may be involved in commodities by investing in companies that produce or mine them.
Bond ETFs
Bond ETFs (Figure 3) may include corporate bonds, government bonds, emerging markets bonds, and even hybrid combinations of all of these that can help lower risk on a portfolio in some instances while generating cash payments to investors.
Figure 3- Daily PDI ETF chart
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International ETFs
While the US is seen as a massive market for ETFs, some of them may be invested in assets available and traded in other countries. For example, some ETFs may invest in stocks across Europe, Asia, or the entire world at once. This also includes other asset classes such as bonds and commodities.
Sector ETFs
Sector investing is slightly more specific than broader index investing and includes the stocks of a certain sector such as financials or health care. They provide less diversification but could be more lucrative than broad market investing if that sector experiences strong growth.