What is an ETF and How Does It Work?
Exchange traded funds, or ETFs, are quickly becoming the investment tool of choice for many individual investors. With an ETF, you can do everything from investing in small-cap stocks to going short on commodities all through one investment package.
In this article we will take a look at how these investments work and why they have become so popular over the last few years.
How do ETFs work?
An ETF is an investment fund that you can buy and sell like a stock. While it might sound complicated, the easiest way to think of them is as baskets of investments packaged together into one product. For example, if you wanted to invest in small-cap stocks but didn’t want all the risk associated with picking individual companies, then buying shares of an ETF that invests in small-cap stocks would make sense.
ETFs can be a great way to diversify your portfolio, and they are also generally less expensive than mutual funds. However, because of the structure of these investments there is usually more trading activity involved with ETFs which could translate into higher fees for investors who buy and sell frequently.
There are many ETFs to choose from, but it’s important for investors to remember that just because an investment is packaged as a “basket of stocks” doesn’t mean they’re safer or less risky than other investments. As with any type of investing, there is no such thing as a guaranteed return on your money.
How did ETFs get started?
ETFs were first used in the U.S. in 1989 by State Street Corporation. State Street Corporation’s ETFs were “index-based,” meaning they tracked a market index.
The first ever ETF was very unique because it mirrored the performance of an asset with no direct ownership (i.e., art). The S&P 500 Index Trust, which debuted on March 24, 1990, gave investors exposure to the broad U.S. stock market in a single stock.
The first ETFs to really catch on were country-specific equity funds, which allowed investors access to economies that were previously off limits (due to factors like high minimum investments or legal restrictions). The “iShares MSCI Mexico Investable Market Index Fund” was the world’s first ever international ETF and helped usher in a new era of diversification for investors.
Another first? The “iShares Barclays 20+ Year Treasury Bond Fund,” the world’s first ETF that invests in an individual bond, was introduced to the marketplace on November 15, 1997. This ETF gave investors with more than five years worth of investing experience access to longer-term bonds without having to take on more risk.
ETFs really started to take off in 2009 when new rules allowed them to be used as long-term investments. This change from trading ETFs one day at a time (daily) to holding an ETF for longer periods of time has made it easier for investors to use ETFs as a way of managing their portfolio.
ETFs have grown rapidly since their introduction and are now one of the largest investment vehicles worldwide, with $15 trillion assets under management globally as of 2016. By 2021, the assets under management are expected to grow by 25%.
What is the difference between an ETF and a mutual fund?
An ETF is a security that tracks an index, a commodity or baskets of assets. Like stocks and bonds, shares in the ETF are traded on public stock exchanges.
Mutual funds bundle together various investments into one package for investors so they can diversify their portfolio inexpensively without having to purchase many different stocks themselves. Mutual funds issue new shares to the public and track a specific index or asset.
What are the types of ETFs?
There are two types of ETFs: index-based and actively managed. Index-based ETF funds replicate the performance of a market index, such as the S&P 500 or Dow Jones Industrial Average. Actively managed ETFs carry an additional cost because they require an investment manager to pick stocks that will outperform their benchmark index in order to deliver a positive return.
Generally investors should avoid actively managed ETFs and only invest in index-based ETFs because of their lower fees, broader coverage, and greater diversification. Actively managed funds tend to have higher expense ratios than index-based products due the additional costs associated with picking specific stocks that outperform market indexes.
What are the advantages of an ETF?
A couple of the advantages of an ETF are that they are traded on a stock exchange and the share price is continuously updated depending on supply and demand.
An ETF can be bought or sold any time during the trading day unlike mutual funds, which have set times for investors to put in orders – before market open, at midday when prices may change based on current conditions (the close), after the market close, and at the end of trading day.
An ETF is a package that bundles many investments together in one investment vehicle. Investors can buy or sell shares anytime during the trading day as long as there are buyers and sellers who want to transact with them.
Another advantage for investors is an ETF's low cost structure which keeps transaction costs low. The individual investors can diversify their holdings while the ETF provider takes care of assembling it for them and receives a commission or “load” only when shares are sold to an investor instead of every time they are bought and sold, like other investments.
An ETF is also generally more tax efficient than many mutual funds because all profits are paid out to investors who then pay the tax
For individual investors, ETFs offer a convenient way to assemble an investment portfolio with one transaction and at competitive prices. For some consumers, this makes it easier than spreading their investments across multiple funds or stocks on their own because they don’t have access to certain types of securities in other markets
What are the disadvantages of an ETF?
The disadvantages of ETFs are that there is a cost to set up the account and also they can be more complicated than other investments. The accounting for an ETF requires the investor, or even their advisor, to do some additional work. But it need not be difficult because most providers offer free tools online for investors who want help with keeping track of their ETFs.
Another disadvantage of an ETF is that they can be less tax-efficient than some other types of investments. This means that, depending on the type and amount invested in an ETF, investors could end up paying more taxes from their returns compared to a mutual fund or common stock portfolio with similar risk exposure.
What are some ETF investing strategies?
There are many different ways to invest in ETFs. Some investors like the convenience of an ETF, and then use a simple buy-and-hold strategy with it. Other investors may want to actively trade their holdings by buying and selling at opportune times for profit, which would require more research into potential investment opportunities.
Investors may also want to invest in ETFs that track a particular index or market. These types of investments are popular because they offer diversification without the hassle and fees involved with multiple individual stocks, bonds or mutual funds.
Another strategy for investing in ETFs include making leveraged bets, which may be appropriate for more aggressive investors. A leveraged bet is when an investor uses borrowed money to make a trade with the hope of earning higher returns than would be possible if they had traded using their own cash. These types of strategies should only be considered by those who can afford losing more than what is initially invested.
How do you evaluate ETFs?
Liquidity is one of the most important aspects to evaluate when looking at an ETF because it can be difficult or impossible for investors with small accounts to buy and sell them. This makes liquidity a primary determinant in whether individual investors should invest in ETFs. For example, if you have $50,000 invested in an investment that has a daily trading volume of $50,000 worth per day (in other words, it is heavily traded), then you will have no problems buying or selling shares.
The next step in evaluating an ETF is to look at its expense ratio. It is important for individual investors to pay attention because this can have a huge impact on their returns over time, especially when it comes from such an inexpensive investment as ETFs.
Moving on to the most basic evaluation of an ETF: How much risk does it represent? Consider whether or not you want your investments to be more defensive or aggressive. Consider your age, income and the amount of money you are willing to invest in this particular type investment before investing in an ETF.
It is important to understand that it is impossible for any investor, no matter how small or large the portfolio, to invest in every sector of the economy at once. Consequently, you will need a diversified investment strategy. This can be done with stocks and bonds but also by using an ETF as part of your portfolio. One attractive aspect of an ETF is that it can provide instant diversification.
How to get started with investing in ETFs
In order to get started with an ETF portfolio, one must first decide on the type of mix that they want. They can serve as a building block for investors who want to take part in traditional stock markets but don’t have enough capital for it.
Before getting started, be sure to do some research. Online courses are available that can teach you how to build an ETF portfolio.
One investment training program is offered by Raging Bull, which is a leading provider of investment training. This resource for investors provides lessons on how to use ETFs, stocks and cash flow in constructing an appropriate portfolio.
Go here to find an article about Jeff Bishop, a Raging Bull co-founder.
I buy and review courses so you don’t have to. Sometimes, I even find courses that are legitimate and worthwhile; and that’s how I accidentally came across one that led me to building a 6-figure business in a little under 5 years. Now, I still review courses because it’s my favorite hobby. 🙂 Learn more about me here.
