What is an Exchange Traded Fund?
The ETF is a security type that involves tracking an index, commodity, sector, or another asset. However, this asset should be sold or purchased as the same stock on a given stock exchange. In addition, the system has structured EFTs to track various aspects of the commodity, including the size of the commodity, price, and other securities. Thus, investors can track specific investment strategies using the ETF.
For example, we have the popular SFDR S&P 500 ETF (SPY), which is structured to track the S&P 500 Index. 1 A single ETF contains various investment types such as commodities, stocks, bonds, and other different investment types. This fund is one of the most marketable securities. Thus it can be quickly sold and bought as it has an associated price.
Key takeaways
In the same way as a stock, the ETF has various securities that can easily trade on a stock exchange.
- As the investor buys the ETF and sells all through, its share prices keep fluctuating in contrast to mutual funds, where trade only occurs one time in the day and the markets closes.
- All investments like bonds, commodities, and stock companies can accommodate them in the ETFs. Whereas some offer international holdings, others provide only US holdings.
- Unlike individual stocks, ETFs have a low expense ratio and lesser broker commissions.
- Similarly, as the stocks, you can also trade the ETFs on exchange for the name Exchange Traded Funds. There will be fluctuation of the ETF price throughout the day, during which its shares are sold and brought on a given market in contrast to mutual funds where the trade occurs one time a day after the closure of the markers. Furthermore, you can not trade mutual funds on the exchange. When comparing to mutual funds, ETFs are less costly and more liquid.
- This fund holds various underlying assets, unlike a stock that only has one. As a result, ETFs provide a popular source for diversification for their multiple assets.
- Across various industries, an ETF can own very many stocks. However, you can isolate the ETF to a particular sector or industry. We have instances where some funds have a global look while others are for US-only offerings. For example, the banking-focused ETFs contain various bank’s stock across the industry.
Types of ETFs
We have a variety of ETFs available for different uses by investors. The uses may include; speculations, income generation, prices, and partly or hedge offset the risk in a portfolio for the investor. Below are some types of ETFs.
● Bond ETFs include corporate bonds, government bonds, and local and state bonds (multiple bonds).
● Industry ETFs- they track specific industries like banking, oil, gas, and technology sector.
● Commodity ETFs- they invest in commodities like gold or oil.
● Currency ETFs- invests in currencies, especially foreign currencies like the Canadian dollar or euro.
● Inverse ETFs- they earn gains by shorting the declining stock. Shorting refers to the selling of stock when expecting the value to decline. Later, when the price is lower, you repurchase it.
Investors are keen on the inverse ETFs as may are not actual ETFs but exchange-traded notes. Despite being a bond, the ETF trades just like a stock, and an issuer such as a bank backs it. It would help if you determined the right ETF for your portfolio. Thus it is good to seek guidance from your broker.
Most of these ETFs are set up like open-ended funds in the US. They are also subject to an investment act 1940. However, this does not affect places where subsequent rules have changed the regulatory requirements. These funds don’t limit the investors on their products.
Buying and selling of ETFs
Traditional brokers and online dealers are the ones involved in this trade. You can check for the best brokers in the Investopedia lists. Alternatively, we have Bettlement and Wealthfront, who are considered standard brokers. These robe-advisors incorporate the ETFs with their investment products.
Real-world ETFs examples
We have listed some of the world’s popular ETFs. Some of them target particular industries, while others create a comprehensive portfolio.
● SPDR S&P 500 (SPY) – is the commonly known and oldest surviving EFTs. It tracks the S&P index 4.
● Ishares Russel 2000 (IMM) – it tracks Russell 2000 small-cap index5.
● Inveso QQQ (QQQ) – it indexes and tracks Nasdaq 100. The Nasdaq 100 contains technology stock.6
● SPDR Dow Jones Industrial Average (DIA) indexes the Dow Jone’s 30 stocks, Industrial Average.7
● Other individual industries like oil (OIH), financial services (XLF), Biotech (BBH), and REITs(IYR)
● Commodity ETFs-they represent any commodity markets such as natural gas (UNG) and crude oil (USO)
● Physically-Backed ETFs- they include those that hold silver bullion and physical gold in the fund.
Advantages and disadvantages of ETFs
Since it will be more costly for investors to purchase many stocks in an individual ETF’s portfolio, the ETFs provide lower costs. In addition, for the exchange, an investor only needs one transaction for each process of buying and selling. Thus, leading to reducing the number of broker fees. Remember, for each trade; a broker charges a specific price. Sometimes when trading on low-cost ETFs, the trader may not charge any fee, thus lowering the cost further.
The total operation and managing cost experts refer to as an expense ratio. Tracking an index makes the ETFs have a significantly low expense ratio. For example, when tracking S&P 500 index, an ETF may from the S&P making contain 500 stocks. Thus it is time-saving, and the companies will manage the funds passively. However, not all the funds track passively.
Pros
● Across the various industries, you can access a lot of stocks.
● Fewer broker’s commission and the expense ratio is low
● Diversification helps in risk management.
● ETFs allow for focus on specific industries.
Cons
● Higher fees for the actively-managed ETFs.
● Some limits diversification like Single industry focus.
● Hindrance of transactions due to lack of liquidity.
Actively-Managed ETFs
With these, the managers of the portfolio are actively involved in trading the company’s shares. In addition, to the funds, they also change the holdings. Thus these ETFs have a high expense ratio than the passive ones. Therefore customers need to determine the fund’s management. The returns from the specific management, either passive or active, should be withholding.
Indexed-stock ETFs
This ETF is characterized by; Index fund diversification, short sales ability, margin buying, and no minimum deposits. Thus, you can purchase as little as one share. However, they all not equally diversified. Other ETFs can contain more concentration in a specific industry, small groups of highly correlated assets.
Dividends and ETFs
The companies which pay dividends also benefit the investors. Companies pay investors this portion of the money as a result of holding up their stock. Thus, the premium paid and earned interest is some of the proportional profits the ETF shareholders make. In addition, in case the company liquidates the funds, the shareholders may get a residual value.
ETFs and Taxes
Since most investors trade through an exchange, ETF is more tax-efficient as compared to mutual funds. More so, anytime an investor wants to sell, the sponsor doesn’t have to redeem the shares or issue new shares. Thus, listing shares of a fund on an exchange will lower the tax cost, unlike when you redeem them. For mutual funds, a shareholder incurs a tax liability any time the investor sells a share.
ETFs Market Impact
With the popularity of the ETFs among investors, there is the creation of many new funds resulting in some of them having low trading volumes. Thus there will be an impact on the purchase of shares for the low-cost ETFs.
There have been questions over whether there can be inflation of stock values and the creation of fragile bubbles with the demand and influence of ETFs. Some of them rely on a portfolio model that investors haven’t tested in the different market conditions. Thus the funds may experience extreme inflows and outflows, thus affecting the market stability negatively.
ETFs have played an important role in market instability, and flash crashes from the financial crisis.
ETF redemption and creation
The creation and redemption mechanism regulates the ETF’s shares supplying. This mechanism involves authorized participants like specialized investors.
Creation
An Authorized Participant (AP) purchases the shares of the stock from an index when additional shares are to be issued. For example, the index may include S&P 500, which the fund tracks. Later they exchange for a new ETF share equivalent to its value. And also, the AP will sell make a profit by selling the shares to the market. Creation is generally the process where an AP sells stocks to an ETF sponsor to get ETF shares.
The creation when there is premium shares trade
Imagine when closing the market, you have a share price of $ 101 from an ETF that you invest in the S&P 500. If the stock’s value which the ETF owns, was $100 per share, then the $101 funds price will be trading at a premium to the net asset value (NAV) of the fund. The reason being the accounting mechanism that determines the asset’s overall value is the net asset value. With the funds NAW, an authorized participant will have an incentive to bring the ETF’s share price into equilibrium. To achieve this, the AP will purchase the stock’s shares which the ETF wants to golf from the market into the portfolio. And sell in return for ETF’s shares. For example, the AP gets ETF’s shares trading at $101 per share in the open market after purchasing stock at the open market at $100 per share. This creation process will, in the end, increase the number ETF’s number. Thus, the increase in the shares will automatically reduce the ETF’s prices with all other things constant.
Redemption
Alternatively, an AP can buy an ETF’s shares in the open market. Then these shares are exchanged back to the sponsor for individual shares stock. These individual shares stock the Ap can sell in the open market. Thus, there is a reduction in the ETF shares produced through a process, redemption. The amount of activity in the creation and redemption will significantly determine the market’s ETF demand. The investors may use it to value the fund’s assets, whether trading at a premium or discount.
Redemption activity when there is a discount at shares trade.
Imagine that an ETF currently trades at $99 per share holds stock in a Russell 2000 small-cap index. If the value of this stock is $100 per share, then the EFT trading is at a discount to the NAV.
To bring the price to its NAV, the EFT’s shares need to be bought in the open market and later sell the same shares. The investors sell in return to the underlying stock portfolio’s shares. For example, the AP will have ownership of the $100 worth of shares in return for shares bought at $99. The process of bringing back the share’s price to its NAV is referred to as redemption. Redemption will significantly reduce the ETF shares in the market. The cost of the shares increases when the supply decreases, thus getting the price closer to the NAV.
