What Are ETF Investments?
Mindful investors can benefit from using exchange-traded funds (ETFs) toward their investment goals. Essentially, an ETF is a group of securities you can trade on a stock exchange via a broker. Whether traditional or alternative investment, you can access ETFs in almost any asset class.
Thousands of ETFs are available worldwide with various assets, stocks, markets, and investment strategies. As with other types of investment funds, you must understand how ETFs work if you want them to make you money. Let’s discuss these funds in more detail and help you choose a strategy that aligns with your investment goals!
How Do ETFs Work?
ETFs are traded when the stock exchanges are open during the day. Each ETF has a ticker symbol, and you can easily track intraday pricing throughout the day.
One way an ETF differentiates from company stock is that there are constantly new shares being created and existing ones being redeemed, meaning the number of outstanding shares of an ETF can fluctuate by the day. Since ETFs can issue and redeem shares continually, their prices generally stay in line with underlying securities.
ETFs were designed for individual investors, but corporate and institutional investors buy and sell creation units, large groups of shares that are exchanged for baskets of the underlying securities.
This means that these investors are vital in upholding the tracking integrity and liquidity of ETFs. Institutions use the arbitrage mechanism of creation units to realign ETF prices that have deviated from their underlying asset values. ETFs would not be a viable option for the general public without this process.
What Are the Types of ETFs?
- Bond ETFs
- Equity ETFs
- Currency ETFs
- Commodity ETFs
- Sustainable ETFs
- Factor ETFs
- Specialty ETFs
Most ETFs are index-based and are designed to replicate a specific benchmark or index. Index ETFs aim to track the index performance of their underlying assets by holding a sample of the index (or all of it). Let’s touch on a few of the most common of these ETFs:
Bond ETFs come with less risk than some other ETFs and provide a steady return. Many investors use this type of ETF to diversify their portfolios and spread their investment risk.
Equity ETFs allow you to target specific sectors that are performing well at a given time period, such as bank stocks or tech stocks, making them one of the most popular types of ETFs among individuals. Equity ETF options range from large business to small business to foreign country stocks.
With currency ETFs, you can invest in a single currency (i.e., U.S. dollar or Euro) or in a basket of currencies. These ETFs let you directly invest in a currency, utilize derivatives, or incorporate a combination of the two.
Make sure you understand what you are purchasing when using derivatives because they tend to add a bit more risk to ETFs. Most individuals who invest in currency ETFs do so to protect or hedge their portfolios, or because they predict the underlying currency to strengthen. Some ETFs involved with overseas markets automatically reduce currency risk.
ETFs can be more challenging to access than stocks, and they’re excellent methods for investing in valuable commodities like gold, silver, and oil. Commodity ETFs are appealing alternatives because they can significantly spread your risk and diversify your portfolio.
With that said, these ETFs are often less transparent than their stock or index counterparts. It’s not uncommon for commodity ETFs to use derivatives instead of directly owning their underlying assets. While derivatives track a commodity’s underlying price, they can also present more risk (i.e. counterparty risk).
More and more sustainable ETFs are becoming available each day. This type of investing melds traditional investment strategies with environmental, governmental, and social philosophies.
Many different kinds of investors are beginning to explore sustainable investing. Evolving perceptions of risk, legislation, and demographic shifts are driving the demand for these ETFs.
This investment strategy targets specific drivers of a return across various asset classes. Factor investing is nothing new; active investment managers and institutional investors have been incorporating factors into their portfolio management for many years. Using rules-based ETFs (“Smart Beta”) is perhaps the most common method of accessing factors.
Leveraged funds and inverse funds are two of the most popular specialty fund types to emerge in recent years. These ETFs are geared toward investors with specific needs. They come with more risk but also significantly higher growth potential.
The primary purpose of leveraged funds is to maximize returns by borrowing more money for investing. These ETFs generally identify the amount they are leveraged (e.g., 2X will borrow an additional $1.50 for every $1 invested).
Inverse funds are known for rising when a target index falls. They work, in many ways, like investors short-selling stocks when their prices drop.
What Are the Benefits of ETFs?
- Diversification and risk management
- Lower operating costs
- Tax advantages
There are four primary benefits to using ETFs instead of traditional open-end funds: diversification and risk management, flexibility, lower operating costs, and tax advantages. Here’s a quick look into each aspect:
Diversification and Risk Management
Many investors aim to quickly incorporate specific sectors, industries, styles, or countries into their portfolios. The wide range of categories available through ETFs can provide investors with easy exposure to specific market segments.
Today, there are ETFs trading in almost every major asset class, currency, and commodity worldwide. What’s more, modern ETF structures are becoming more innovative and conducive to specific trading and investment strategies by the day.
As one example, you could purchase or sell stock market volatility or invest continually in a high-yielding currency through ETFs. You could even diversify risk in a specific sector by purchasing an ETF that shorts the targeted industry (or by shorting an industry-sector ETF).
All traditional open-end mutual fund shares are traded with the company issuing the shares once a day after the markets close. Since you must wait to trade until the net asset value (NAV) is announced at the end of the day, you will not know what you paid for new shares as you purchase that day, nor will you know what you will make from sold shares that day.
While this type of trading works for most long-term investing strategies, it’s not ideal for individuals who need more flexibility. ETFs are purchased and sold throughout the day, and the pricing of all shares remains constant during exchange hours. The ability to track the changing intraday value of a fund’s underlying assets and trade immediately makes it easy to manage your portfolio.
Lower Operating Costs
All managed investment funds incur operating costs. These can include everything from administrative and marketing expenses to portfolio management and custody fees. It’s essential to understand the costs of any fund to project its returns. Historically, funds that cost less to invest in usually bring a higher return.
ETF operating expenses are typically lower than those of open-end mutual funds. Brokerage firms handle many of the service-related costs, and when a broker doesn’t require a call center or staff to respond to thousands of inquiries, it can significantly reduce the administrative expenses of an ETF. You also don’t have to pay as much in transfers, notifications, and statements on ETFs.
There are two primary tax benefits of investing in ETFs. They usually incur fewer capital gains taxes than mutual funds. What’s more, you only have to pay capital gains taxes on ETFs when you sell them, as opposed to mutual funds where the taxes are passed on through the duration of the investment.
What Are the Drawbacks of ETFs?
As with any investment, ETFs are not without disadvantages. For example, there is an ETF to replicate virtually every U.S. market sector, but there are no international ETFs and the few foreign investment options available offer much less control. Also, most ETFs trade at a low volume and the bid-ask spread of such an ETF can prove too wide for some investors.
Another drawback of ETFs is that they are less volatile because they include a package of diversified holdings instead of a single stock. With long-term investing, low volatility can work in your favor. But if an asset doesn’t move much, it’s likely not going to yield a significant return in a short period.
You’ll remember that ETFs come with lower operating costs than mutual funds, but they’re not free. ETFs are not purely passive, meaning you will need to pay one or more fund managers to manage your holdings. Investors who can manage their own funds may benefit from other strategies.
These drawbacks are not significant enough to deter some investors from pursuing ETFs. The key is to research and determine whether they fit into your overall investment plans.
Investing in ETFs comes with pros and cons. All things considered, they are ideal for beginner inventors because they can provide lower risk, lower costs, more diversification, more flexibility, tax benefits, and many other perks. They can also help seasoned investors looking to target specific sectors.
With that said, ETFs can prove most effective when combined with long-term strategies. If you’re aiming to incorporate alternative investments into your portfolio, consider working with Vint. Our first-of-its-kind platform is fully transparent and provides investors with a expansive range of SEC-qualified fine wine shares from around the world.
Sources: What Are Bond ETFs and How Do They Work? | The Balance 14 Commodity ETFs to Ease Inflation Worries | Kiplinger What Is a Good ETF Expense Ratio? | The Motley Fool