-
What is an ETF
-
How does an ETF work
-
Key characteristics of ETFs
What is an ETF?
ETF stands for an Exchange Traded Fund. It trades exactly like a stock on a
stock exchange.
An ETF, or Exchange-Traded Fund, is gaining popularity among investors who
look to diversify their holdings at a lost cost.
There is a wide variety of ETFs, but most are passive investment vehicles,
meaning they aim to track the performance of an underlying security or
index.
There are also actively managed funds that aim to outperform the market,
which charge higher fees for the service.
ETFs have features from both stocks and managed funds and are positioned in
a sweet spot between the two.
How does an ETF work?
Investing in an ETF gives immediate access to a wide array of stocks,
thereby providing diversification.
Unlike actively managed funds, ETFs are designed not to outperform the
market index but to mirror its performance, potentially leading to more
stable returns.
Due to their passive management strategy aimed at tracking an index, ETFs
typically incur lower fees than actively managed funds, where fund managers
charge higher fees to surpass a specific index or benchmark performance by
hoping to generate so-called alpha returns.
Additionally, ETFs provide the advantage of liquidity, allowing investors
to buy and sell shares at their discretion throughout the trading day.
An ETF holds assets such as stocks, commodities, or bonds. It generally
operates with an arbitrage mechanism designed to keep it trading close to
its net asset value, though deviations can sometimes happen.
However, unlike the fixed share quantity of company stock, an ETF’s share
count can vary daily due to the ongoing process of issuing new shares and
redeeming existing ones.
Key characteristics of ETFs:
Diversification: ETFs often hold a wide array of
securities, providing investors with an easy way to diversify their
portfolios.
Liquidity: Since ETFs are traded on stock exchanges, they
can be bought and sold throughout the trading day at market prices, which
can differ from the fund’s net asset value (NAV).
Cost Efficiency: ETFs generally have lower expense ratios
than mutual funds. However, buying and selling ETFs incur brokerage fees,
as with any other stock transactions.
Transparency: Most ETFs regularly disclose their holdings,
making it easy for investors to understand what they own.
Tax Efficiency: ETFs are structured to allow investors to
buy and sell shares without triggering capital gains taxes, making them
more tax-efficient than mutual funds.
How to invest in ETF?
Investing in ETFs is a straightforward process that involves a few key
steps. Here’s how you can start investing in ETFs:
-
Open an Investment Account: The first step is to open
a brokerage account if you don’t already have one. Many brokers offer a
wide range of ETFs to choose from, including those focusing on specific
sectors, indices, or investment strategies.
-
Research ETFs: Spend time researching different ETFs
to identify those that align with your investment goals. Look at the
ETF’s focus area (e.g., technology, healthcare, international markets),
past performance, expense ratio (the cost of owning the ETF), and asset
allocation.
-
Place a Trade: Once you’ve selected an ETF, you can
place a trade through your brokerage account. You’ll need to know the
ETF’s ticker symbol (a unique series of letters assigned to a publicly
traded asset). Decide on the number of shares you want to buy and the
type of order:
i) Market Order: Executes the trade immediately at the
current market price.
ii) Limit Order: This allows you to set a specific price
at which you want to buy the ETF, and the order is only executed if the
market price meets or goes below your set price.
-
Consider Rebalancing: Over time, the value of
different investments in your portfolio will change, which may lead you
to rebalance your portfolio. This could involve buying or selling shares
of your ETF or investing in new ETFs to maintain your desired asset
allocation.
ETFs vs Mutual Funds
In a way, ETFs are like mutual funds, investing in a basket of securities;
however, unlike mutual funds, ETFs are traded throughout the day, just like
stocks.
When evaluated against other investment options, ETFs distinguish
themselves in several key aspects. They are known for their lower
operational costs, enhanced diversification opportunities, and a growing
variety of choices available to investors.
In the comparison between ETFs and mutual funds, one notable advantage of
ETFs is their generally lower expense ratios, which contribute
significantly to their attractiveness.
Moreover, ETFs tend to be more tax-efficient than mutual funds. Mutual
funds, particularly those that are actively managed, often experience
higher levels of trading activity, leading to potential capital gains.
Additionally, when mutual fund investors decide to sell their shares, the
fund managers may need to liquidate securities to facilitate these
redemptions, potentially generating further capital gains. In both
instances, the investors must bear the tax implications.
The management approach of these investment vehicles also differs; mutual
funds are typically actively managed, aiming to outperform a benchmark
index, whereas ETFs are often passively managed, tracking the performance
of an index (though there are actively managed ETFs available).