What is exchange traded funds (ETF) and how do they work?
If you want to enjoy the combined benefits of stock trading and mutual funds diversification, Exchange-Traded Funds or ETFs can be your preferred option. In this guide, we will cover the basic things like what is ETF stock in detail and other important things related to it.
You can think of ETF funds as a basket of stocks that are traded on an exchange.
On one hand, ETFs possess the flexibility to be bought and sold just like individual securities with regular ups and downs based on stock market conditions.
On the other side, you will become an owner of a diversified portfolio that is managed by professional fund managers.
Hence, this offers you the taste of mutual funds. Therefore, you can conveniently go for this investment option to enjoy stock market returns if you have limited knowledge or maybe don’t have time to track the market regularly.
What is ETF stock? | Overview –
As it can be easily inferred from the name, ETFs are funds that allow you to trade just like any stock on an exchange.
You can buy it anytime and also sell it anytime you want just like a stock.
An ETF stock is generally based on indices, sectors, commodities, or any other asset classes.
Mutual funds are neither traded on an exchange nor allow you to trade throughout the day, rather it is traded only once per day.
But, ETFs offer you that ease and flexibility like stocks. The ETFs also have a lower expense ratio or fees than other types of funds available.
How do ETFs work?
When you buy a stock, it’s just one company or business. However, ETFs are a portfolio of stocks or hold multiple underlying assets.
This diversified portfolio makes ETFs an ideal investment choice.
The portfolio can have stocks of various sectors or it can be sector-oriented as well. Like, for instance, there can be an ETF that contains various banking stocks and hence it will track the banking sector only.
The working mechanism of ETFs can be summed up as follows:
There can be a fund provider who will design a fund with the underlying assets that they own to track the performance and growth.
That fund provider will then list the shares of that fund on an exchange for the investors to buy.
On investing in those ETF shares, the investors will become partial owners of that portion.
Based on the index that the particular ETF is tracking, your invested money in the ETF stocks will grow, pay you dividends, etc.
Let me take an example now to make this crystal clear for you. A popular example can be SPDR S&P 500 ETF (SPY) which is a fund traded on the exchange tracking the S&P 500 index.
The ETF will comprise the portfolio of the same companies that are included in the S&P 500 index.
You can also consider another popular fund ‘Vanguard S&P 500 ETF’ which also tracks the S&P 500 index.
So, this is an overall explanation of how ETFs work. Hope you have got the philosophy behind it clearly.
Let’s now go through the different types of ETFs in the next section.
Categorization of ETFs –
Different types of ETFs are there based on different purposes like income generation, speculation, or hedging your portfolio. Some of the various types of ETFs are as follows:
- Stock ETFs:
These ETFs are comprised of a basket of stocks that can be of different sectors. They generally contain high performer stocks of various industries which possess a growth potentiality in the long term.
So, it is mainly for increasing your invested money through the power of compounding.
- Sector ETFs:
There are different sectors of businesses and hence the stock market is also divided into various sectors.
Like, the US equity market is divided into 11 sectors and one sector will have many companies and hence many stocks.
So, sector ETFs are comprised of different stocks of one sector like IT, banking, or health care.
These can be somewhat riskier than stock ETFs because they are concentrated only on one sector.
- Bond ETFs:
The bond ETFs does not have a maturity date unlike individual bonds and hence they generate regular income for the investors. The fund will have various individual bonds and thus you will get the interests generated from those bonds. They are of much lower risk than the stock ETFs.
- Commodity ETFs:
We all know what commodities are, right? They are raw materials like gold, silver, crude oil, etc. So commodities ETFs are funds that comprise these securities. You can keep commodity ETFs in your portfolio especially for hedging which means to protect your portfolio during a bearish market.
- Currency ETFs:
The ETFs that are used to track the performance of currency pairs including domestic and foreign currencies are known as currency ETFs. They have various advantages like speculation and also hedging against the volatility in forex markets.
These are the main types of ETFs available. However, there are some more like International ETFs, Inverse ETFs, etc.
Positives and negatives of ETFs as an investment option –
Everything in this world comes with several advantages and disadvantages. ETFs will not be an exception too. In this section, we will discuss the various advantages and disadvantages of Exchanged Traded Funds.
Advantages or Pros of ETFs –
- Investment cost: As compared to mutual funds, ETFs have a lower expense ratio. It’s because fund managers of ETFs follow a passive investment strategy and hence the management fee is lower. This will result in greater returns for the investors in the long run. But, you will need to pay some brokerage charges while buying or selling ETFs. Still, the changes required will be lesser than mutual funds.
- Lock-in period: As mentioned earlier, ETFs can be traded throughout the day just like any stock on an exchange. Hence, there is no lock-in period for investing in ETFs. Therefore, you can liquidate by selling them anytime and meet your financial needs.
- Ease of trading: Mutual funds are traded once per day while ETFs are traded just like any stock. Values also change throughout the day. So, you can easily buy and sell ETFs daily similar to intraday trading.
- Diversification of portfolio: Buying individual company shares can cost you more. So, it’s a better idea to buy ETFs because they already have a diversified portfolio. Thus, ETF can be a much cost-effective investment strategy.
- Transparency: Mutual funds disclose the holdings quarterly whereas ETFs do the same regularly.
- Passive investment: You don’t need to track the market closely if you invest in ETFs because there will be professionals to manage the portfolio constituents of the ETFs. So, it can be a good option for novice traders too with little or no idea about stock markets.
Disadvantages or Cons of ETFs –
- Demat Account: You can directly invest in a mutual fund with various companies (AMCs). However, for ETFs, you need to open a Demat account for doing the transaction.
- Market: Since ETF is a fund consisting of various stocks, so they will be subjected to market volatility and risks.
- Brokerage: Just like trading in stocks, trading in ETFs also does incur brokerage charges.
How to select the best ETFs? || Investing Guide –
Randomly investing in any ETF will not be beneficial unless you choose the best one. For selecting the best ETFs, you must consider the following factors:
Time of investment –
Before investing in ETFs, one must have a basic idea of the market condition.
Selecting the right time to invest based on the market health is essential as that will impact the returns a lot in the long run.
For instance, if you invest in such a time when the market valuation is higher, then you may be at a loss when the market corrects itself for the next few months or years. Moreover, it is essential to be sure about the duration of investment because investing in ETFs can help you to reduce your tax liabilities.
The strategy of investment –
It is always advised to invest in the stock market after conducting your own research. Since there are various ETFs available, you must do a thorough analysis or take help from your financial advisor.
But, please don’t select any investment option just by getting information from someone else or news channels.
Various costs involved –
Exchange-Traded Funds have a lower expense ratio, but investors should be aware of other costs involved in ETF trading like brokerage fees, etc.
This is the reason you need to do proper research before investing in any ETF or stock.
Error in tracking –
You must check the past performance of the fund before investing. This will help you to get an idea of the tracking error of that particular ETF.
If you see that there is a huge deviation from the index that it is tracking, then it will be better to avoid investing in those ETFs.
It’s because the fund manager is not able to manage efficiently.
Best ETFs to consider investing –
Here, we will provide you with some real-world examples of ETFs that you can consider to invest in. ETF to invest in, ETF List:
- SPDR S&P 500 ETF (SPY) – S&P 500 index.
- Invesco QQQ (QQQ) – Nasdaq 100 index.
- iShares Russell 2000 (IWM) – Russell 2000 small-cap index.
- SPDR Gold Shares (GLD) – for tracking gold.
- SPDR Dow Jones Industrial Average (DIA) – Dow Jones Industrial Average.
- Vanguard 500 ETF – S&P 500 index.
ETF vs Mutual Funds (MFs) | Comparison Chart –
Most people confuse that ETFs and MFs are the same, but it’s not so. You can think one to be a subset of the other but not equal. For making you understand that better, we have designed a comparison chart between them.
Frequently Asked Questions (FAQs) –
Q1. How to find the right ETF to invest in?
A: ETFs are usually passively managed investment options tracking an index. So, one should go for those ETFs based on their risk appetite.
Like, if they want to take a lower risk, then you can invest in those ETFs that track the large-cap index.
On the other hand, if you want to achieve better returns and can digest more risk, then mid or small-cap index ETFs can also be a good option.
Moreover, there are actively managed ETFs too but they will charge you more costs. Thus, talk to yourself and then choose the type of ETFs that you want.
For taking appropriate decisions, you can also go through the above discussion and choose based on your preferences.
Q2. Which is better – ETF or mutual funds?
A: Both ETFs and MFs come with their own advantages and disadvantages. You can go through the comparison chart above to know the differences.
We suggest you divide your investment into both. However, the proportion of money to invest in both schemes depends on you.
Hope you have gained enough knowledge regarding what is ETF stocks and how they work.
We have also included other important and related information that you must know before investing.
This is an overall guide that can help you to get enough knowledge and there is no requirement to search through other sources.
Thanks for taking out your time and going through this full guide on ETFs. Stay safe and take care, Happy Investing!