Do you have any ETFs in your portfolio? If you want diversification, simplicity, and convenience, exchange-traded funds may be the investment vehicle for you. Let’s dive into what an ETF is.
What is an ETF? – Exchange-Traded Fund
An exchange-traded fund (ETF) is a bundle of financial securities (such as stocks, bonds, commodities, etc) that are packaged together into one fund and trade on an exchange.
ETFs trade like a stock and shares are available for purchase through a broker. ETFs can offer an investment vehicle with the most attractive characteristics: variety of choice, diversification, flexibility, convenience, tax efficiency, and liquidity.
ETFs can have holdings of US securities and international securities. They can focus on a specific sector or industry. And they can be formed with specific investment styles. The possibilities and mixtures are endless and there is an exchange-traded fund for everyone out there.
These funds provide all investors, from big to small, a chance to build their portfolio with low-cost and diversified funds. With one ETF, an investor can have exposure to hundreds or thousands of underlying securities. Their flexibility, ease, and cost-effectiveness make the exchange-traded fund a popular choice.
The ETF market has grown from having $400+ billion in assets in 2005 to $4,600+ billion in 2018 ($4.6 trillion).
Trades Just Like a Stock
An ETF is bought and sold on an exchange like any other stock would be. ETFs have tickers like a stock would. For example, the fund SPY is the SPDR S&P 500 ETF that tracks the S&P 500 index.
Any investor can go onto their Robinhood account and purchase an ETF during market hours. The price of the ETF goes up and down during the day, also similar to a stock but different to a mutual fund.
There are no minimum investment amounts required. If an ETF is trading at $15 a share, anyone with $15 can become an investor and gain access to a diverse portfolio.
ETFs offer investors a security type where they can buy and sell a fund with exposure to anything they want with just a few button clicks. Additionally, ETFs are typically more cost-effective and liquid than mutual funds that offer the same exposure.
How ETFs Work
Explaining how ETFs work can be summarized in three simple steps:
1. The fund provider purchases the underlying assets to build the fund’s portfolio
2. The fund then sells shares of the fund to investors on an exchange
3. Investors own a portion of the fund itself but don’t own the underlying assets the fund is comprised of
Why ETFs are Growing in Popularity – The Benefits
ETFs have become massively popular by all investor types for many reasons:
Variety – The ever-expanding variety of ETFs can surely meet the criteria of any investor out there.
Flexibility – ETFs are more flexible when compared to other types of funds and securities. Investors can buy and sell during trading hours just like a stock. There are no investment minimums like there can be with mutual funds and index funds.
Diversification – Diversification is a must-have for investors. Investors attempting to create a diversified portfolio on their own can be costly and is likely to fail. ETFs can offer one fund that meets all your diversification needs.
Transparency – Many exchange-traded funds publish their holdings each day. This transparency is appreciated by investors so they can know what their fund is holding at any time.
Cost-effectiveness – Costs of investing in an ETF tend to be lower than other types of funds. Owning them usually results in lower trading fees, lower management fees, and tax efficiency.
Liquidity – ETFs trade like stocks on an exchange. The investor can buy or sell their shares of the fund throughout the trading day. This liquidity is reassuring to investors. They know that they can buy in at any attractive price and sell their shares whenever they decide to.
Types of ETFs
Stocks – Holds a group of stocks only.
Bonds – Holds a collection of bonds.
Currencies – Invest in world currencies.
Commodities – Designed to hold commodities such as oil, gold, corn, etc.
Mixed – Hold a mixture of asset types to achieve a particular risk profile or focus.
US – Invest in US assets only
International – Hold international securities to give investors worldwide investment exposure.
Sector and Industry – Invest in securities within a specific sector or industry. For example, there are ETFs that focus on technology, renewable energy, oil, and hospitality.
Index – Index ETFs buy assets to mimic an underlying index. SPY is an example of an ETF that attempts to mirror the S&P 500 index.
Small-cap, large-cap, etc – Funds can focus their holdings on small-cap stocks only or large-cap stocks only if they choose.
Growth, income, defensive, etc – Designed specifically for a particular investment outcome. A growth ETF will hold assets with higher growth potential. A conservative investor can invest in a defensive ETF that holds assets that are lower risk.
Actively managed – Funds with managers and teams actively using their judgement for investment decisions. For this “expertise” active funds typically come with higher fees.
Passively managed – Funds that operate without the need of judgement from a fund manager. An index ETF is an example of a passively managed ETF. The fund automatically adjusts to mirror the composition of the underlying index.
ETF vs Stocks, Mutual Funds, and Index Funds
ETF vs Stocks
ETFs and stocks are similar in that they are both purchased on an exchange and have a ticker symbol. Both securities can pass on dividends to the investor.
With a stock, each purchase an investor makes is for one company. If you want the stock of 20 companies, you will need to make 20 different purchases.
This can be costly if you have to pay trading commissions for each transaction. With an ETF, you can make one purchase and have access to hundreds of securities.
ETF vs Mutual Funds
ETFs and mutual funds are similar in providing funds that offer a mix of asset types. The differences come from the management style, the way each fund is purchased, and fees.
Mutual funds are typically actively managed by a fund manager, whereas an ETF is passively managed to track the underlying securities that make up the fund. Since mutual funds can be actively managed, they will have higher fees to compensate the management team.
One attraction of the exchange-traded fund is the ability to purchase the fund on an exchange like a stock. With mutual funds, investors can only purchase shares of the fund at the end of each trading day, not during the trading day. This lack of liquidity can be a turn off to some investors.
ETF vs Index Funds
Index funds are funds that mirror an underlying index. An ETF can also mirror an underlying index, so the two are similar in that sense.
So why choose one over the other? ETFs can be purchased throughout the trading day whereas index funds are purchased at market close. Index funds usually have an account minimum to purchase and invest. As for fees, both ETFs and index funds are cheap to own.
Differences between fund types, commissions, and providers/brokers can make one better than the other. Ultimately, an exchange-traded fund offers a more flexible and convenient way to invest in a fund that tracks a market index.
Real Examples of ETFs – Exchange Traded Funds
Below are a variety of examples of popular exchange-traded funds:
- SPY: SPDR S&P 500 ETF
- VOO: Vaguard S&P 500 ETF
- IWF: iShares Russell 1000 Growth ETF
- VTV: Vanguard Value ETF
- SCHD: Schwab US Dividend Equity ETF
- VEA: Vanguard FTSE Developed Markets ETF
- VWO: Vanguard FTSE Emerging Markets ETF
- AGG: iShares Core US Aggregate Bond ETF
- GLD: SPDR Gold Trust
- EWZ: iShares MSCI Brazil ETF
Drawbacks of ETFs
Overall, the benefits of ETFs largely outweigh the drawbacks. Many of the drawbacks are specific to certain funds, investors, and circumstances.
If investors are frequently buying and selling shares of ETFs, trading costs can quickly add up if you broker charges commissions for purchases and sales. This can eat into your returns.
If you use a commission-free broker like Robinhood or don’t trade frequently, trading costs won’t be an issue.
ETFs usually have low expense ratios, but that isn’t the case for all funds. Some funds can have high management fees. It is the investor’s responsibility to ensure they are investing in a fund that has minimal fees or at least has fees that are justified.
Easy to overtrade
Ease and convenience can be a double-edged sword with ETFs. The ability to buy and sell frequently can lead investors into overtrading. They may buy and sell too often. This can hurt returns, increase costs, and take investors out of the market when they should be in the market.
Easy to unintentionally purchase risky funds
It is easy for investors to unintentionally purchase something they do not want.
They may think they are purchasing an ETF that tracks the S&P 500, but they accidentally purchase shares in a fund that tracks the S&P 500 with 3x leverage.
Or, they are looking to buy a gold ETF because they believe gold is on the rise. However, they accidentally buy an inverse gold ETF, which earns profit when the price of gold goes down.
Investors need to read things through and understand what they are purchasing.
Exchange traded funds have become increasingly popular for their flexibility, options, convenience, and low costs. Investors can choose from a seemingly endless variety of ETFs to find a fund that meets their investment needs.
It is important to know what ETFs are and how they work. Also important is knowing how they differ from mutual funds and index funds. This knowledge will help you (the investor) in choosing the best option for you.
While the benefits of ETFs largely outweigh the drawbacks, you should still be aware of what the drawbacks are so you can avoid them.