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Investing 101

Investing in ETFs

August 29, 2019


For a beginner, making the right investment choice is overwhelming. Furthermore, it is more confusing for a layperson to decide which investment vehicles are the best and which ones come with the highest ROIs. The investment pool is diverse and offers several options.

In the earlier posts, you have already read about stocks, bonds, index funds, and mutual funds. The list does not end here. There are more options, Exchange-Traded Funds (ETFs) being one of them. Like any other financial instrument, ETFs also have some merits and demerits. Moreover, it is important to know how you can buy or sell ETFs to have a diversified portfolio.

What Is an ETF?

Exchange-Traded Fund or ETF, as you know, is a basket of different financial securities that trade on an exchange similar to a stock. The collection includes stocks, bonds, commodities, or a combination of these. While ETFs offer the diversification of mutual funds, they also provide the ease of stock trading.

Hence, ETFs are essentially index funds –tracking multiple stock market indexes –that are traded like stocks. An exchange-traded fund is marketable i.e. you can buy and sell ETFs on associated prices. Since ETFs are traded on an exchange, the price of ETF shares keeps changing throughout the day.

How ETFs work?

ETFs operate very much in the same ways as index funds do. They also track a particular market index like the S&P500. In comparison to mutual funds, ETFs are relatively cheap. Hence, with ETFs, you can buy and sell a collection of assets on an exchange.

The ETF provider is the owner of the assets who track the indexes and then sell the shares to the investors. Thus, the investor owns a fraction of an ETF and not the underlying asset. The share price of an ETF can range from less than $100 to $300 or more.

The price of an ETF is determined based on supply and demand. Also, ETF trading takes place throughout the day, and the net asset value (NAV) of an ETF is published every 15 seconds. So, the market price of an ETF can differ from its NAV.

Types of ETFs

With an exchange-traded fund, you can own as many stocks as you want across different industries or major shares of one sector. Hence, you can choose from a variety of ETFs to generate income and balance out the risks. Here are some of the ETFs.

Market ETFs

Market ETFs allow the investor to track a major market index within the US stock market. The primary goal of a market ETF is the emulation of an underlying index. While some market ETFs track low-volume indexes, most of them are active on an exchange floor. QQQQ is a classic example of a market ETF that tracks the Nasdaq-100 index.

Foreign ETFs

You may step out of the US market to boast a market index ETF and choose from many foreign ETFs as well. Hence, foreign ETFs give you international exposure, thereby evading you against the risk of foreign investment.  EWG is one of the countries or regional ETFs that track the MSCI Germany Index.

Bond ETFs

They might include government bonds, corporate bonds, and municipal bonds. Bond ETFs are difficult to construct as they track low-liquidity investment indexes.  Also, Bond ETFs are not much active in the secondary market for the reason that investors hold them until maturity.  

However, ETF providers, such as Barclays, have created bond funds like the SPDR Capital Long Credit Bond ETF (LWC), allowing investing in the bond market, thereby enjoying the benefits of ETFs.

Industry ETFs

Industry ETFs track a sector index of a particular industry. These investment vehicles give exposure to the investor to industries like technology, pharmaceuticals, banking, or the petroleum industry.

Foreign Currency ETFs

You may also invest in Currency ETFs such as the Canadian dollar or Euro. With currency ETFs, you don’t have to complete complex transactions and track a foreign currency. Interestingly, some Currency ETFs track a collection of currencies, hence giving access to several foreign currencies.

Commodity ETFs

Similar to industry ETFs, Commodity ETFs target particular areas of the market. However, when you purchase a commodity ETF, like crude oil or gold, you don’t buy the commodity. Rather, you emulate the price of the underlying commodity.

Inverse ETFs

Inverse ETFs are a means to earn profit through shorting stocks. When the market plummets, and you expect a decline in value, you can sell the stock and repurchase it at a lower cost.

Merits and Risks of Investing in ETFs

Now that you are familiar with the various types of ETFs you can invest in, it is paramount to evaluate the pros and cons that come with ETFs.

Advantages

  • First, ETFs give you access to multiple stocks across various industries at a low cost. Imagine how expensive it would be to purchase all the stocks in an ETF portfolio individually.
  • Also, ETFs have lower expense ratio i.e. the cost to manage and operate the fund.
  • You have to make a transaction twice only: one at the time of buying, and the other at the time of selling. Thus, it entails fewer broker commissions, thereby reducing the cost further.
  • Investing in ETFs is a smart way to target a specific industry, a part of the bond market (like the small-cap stocks), or the whole index (such as the S&P 500).
  • ETFs are easy-to-handle as you can buy or sell them throughout the trading day. Also, you can get out of an exchange-traded fund at any given time during the trading day.

Risks

  • While ETFs have a low management cost, the expense ratio varies widely from fund to fund based on the issuer.
  • Also, some ETFs tracking the same index have varying costs.
  • Most ETFs are managed passively and track market indexes. However, if an investor chooses to have an active-managed ETF, it comes with a higher cost.
  • Lastly, ETFs have a potential threat of closure. An ETF may shut at any time, given that the fund does not bring enough assets to meet the administrative expenses.

FAQs

How can I invest in an ETF?

You can trade ETFs through online and standard broker-dealers. Alternatively, Robo-advisor can construct your portfolio by making use of ETFs in their investment vehicle. 

What is a better option, ETFs or Mutual Funds?

ETFs are relatively cheaper than mutual funds. Also, ETFs are tax-efficient as most of the buying and selling takes place through an exchange.

What are some of the popular ETFs in the market?

While some ETFs target specific industries, others have a global outlook. The famous ETFs on the market include SPDR S&P 500 (SPY),iShares Russell 2000 (IWM), Invesco QQQ (QQQ), and SPDR Dow Jones Industrial Average (DIA).

Foot Note

Every investment instrument has some positives.  Likewise, no investment vehicle is risk-free. Before putting your money in any of the available options, it is better to be informed about the potential choices. Weigh in the benefits and if the risks outplay the advantages, drop the idea. Yes, ETFs also have some risks, but they are a safe investment option in contrast to many other financial vehicles.  

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