Money Matters

Everything You Should Know About ETFs

ETFs capitalize on the advantages of stocks and mutual funds: they're diversified, easy to trade, transparent, and tax-efficient. So, what's the catch?

ETF stands for Exchange Traded Fund: this is an investment option that combines the most enticing aspects of traditional stocks and mutual funds. ETFs are essentially funds composed of various equity stocks that are traded on an exchange throughout the trading day, and they typically have little to no commission fees.

How Do ETFs Work?

Different types of ETFs encompass varying levels of risk. For example, a growth ETF will most likely allocate investments into smaller companies and is inherently riskier than an ETF that only invests in blue chips or well-established firms. 

When you purchase an ETF, you own a portion of the fund rather than the individual stocks that comprise the fund itself. However, several ETFs allow you to collect dividend payments from the companies that construct the fund. Many ETF distributors reinvest these lump sums back into the fund, but that varies from firm to firm.

Why Do ETFs Exist?

ETFs exist to capitalize on the advantages and alleviate the disadvantages of traditional stocks and common mutual funds.

  • Traditional assets are easy to trade on any given exchange. A single investment of common equity stock can be bought or sold at any point throughout the trading day. Investors typically build their portfolios with several equity stocks to diversify and limit risk.
  • Mutual funds are comparatively difficult to trade. However, they address diversification by allocating investments into many different firms rather than just one. 

Therefore, the ETF attempts to combine the positive qualities of both forms of investing while omitting their deficiencies. In other words, ETFs are easy to trade, like traditional stock, and diversify investments over various companies to limit risk, just as mutual funds do. 

ETFs also allow you to avoid higher tax rates that are typically associated with mutual funds. As mutual funds are managed more actively than ETFs, more transactions are performed within the fund. Each transaction is performed with the goal of producing higher profits, though each sale incurs taxation. Therefore, most ETFs avoid the high taxes commonly associated with mutual funds.

Where Can You Find Them?

Most online brokerage firms offer ETF trading. The common investing brokerage sites like Fidelity, TD Ameritrade, and ETrade allow you to trade ETFs with ease on their platforms. Anyone with a standard brokerage account at these firms can purchase an ETF.

The management of ETFs is typically more passive than that of a mutual fund. However, ETFs with disciplined management are available as well, though they often entail higher fees. Charles Schwab, Vanguard, and other investment companies also create ETFs.

Some ETFs track the S&P 500 index, such as the SPDR fund. ETFs may also track other stock indices such as the Dow Jones Industrial Average or the NASDAQ. In using funds that track an underlying index, you can rest assured that your fund will perform in unison with indices.

Pros and Cons of ETFs

As with any form of investment, ETFs may be more favorable to certain investors, and it is important to analyze the positive and negative qualities. ETFs offer various pros and cons.

Pros

  • Diversification: ETFs offer diversification. There are varying levels of risk associated with the different types of ETFs. However, investing in several companies protects you from the total loss of principal. It is plausible that one firm goes bankrupt but unlikely that one hundred firms do.
  • Transparency: It can be easy to monitor the progress/performance of an ETF. The transparency available in tracking the sustainability of these funds is comparable to that of traditional equity stock. You can use this aspect of an ETF to monitor the progression of your investment carefully and make trading decisions accordingly. Mutual funds and bonds are examples of assets that are harder to track.
  • Tax efficiency: Active management is prevalent with mutual funds. Since mutual fund managers make regular transactions, they also incur frequent taxation. These tax payments diminish the possibility of returns. ETF managers make transactions in the fund less frequently, which means they incur fewer taxes. The prospect of tax efficiency entices many investors to choose ETFs over mutual funds.
  • Fewer capital gains taxes: Capital gains are proceeds from the sale of individual stocks. The fund will move up or down based on the performance of the stocks within the fund. When a fund profits from the transactions of any assets within the fund, those capital gains will be distributed accordingly. Since mutual funds typically have higher turnover rates- or more performed transactions within the fund- they will have more capital gains to reward. However, these gains are taxed, making investments in an ETF seemingly less convoluted in terms of taxation. The lack of management fees due to the issuer or fund manager represents an advantage that ETFs have over mutual funds.
  • Lower expense ratios: Expense ratios are typically lower in ETFs than in mutual funds. An expense ratio is the total amount of fund assets used for administrative fees. If an expense ratio is calculated as 0.50%, then the owner of an ETF will pay $50 for every $10,000 invested into the fund. This process is the same for mutual funds, though the expense ratios are often much higher than that of an ETF. The avoidance of such fees and remarkable tax efficiency makes an ETF more low-cost than a mutual fund composed of similar assets. Low expense ratios create this advantage. 
  • Higher liquidity: ETFs are more liquid than mutual funds, meaning that an ETF can be easier and more convenient to trade. Anyone attempting to ensure the ability to secure cash flow at any given moment enjoys this quality of ETFs. The volatility of each type of fund is comparable, though ETF shares are usually easier to trade. ETFs trade at market price, similarly to traditional equity stocks. The prospectus of each fund can be similar, though intraday transactions and similar pricing models give ETFs an advantage over mutual funds.

Cons

  • Commission fees: ETFs are subject to commission fees distributed by their online broker. While several ETFs are bought and sold free of charge, many brokerages charge an additional expense to their investors.
  • Fewer profits due to passive management: Passive management refers to the transactions performed within a fund. If a fund is passively managed, this means there are hardly any transactions performed within the fund. Actively managed accounts perform more transactions, thus capitalizing on the important rule of investing: buy low and sell high. The difference in profits between an actively and passively managed account can be meaningful. Therefore, the fact that ETFs are more passively managed than mutual funds means that each stock within the fund may yield less profit. 
  • Fewer profits in the short run due to less volatility: In comparison with individual stock picks, ETFs are less volatile in the short run. This means that if you are seeking quick returns, you will most likely be disappointed by the profits yielded by an ETF in the short run. If you seek the thrill of short-term volatility, you may steer clear of ETF investments. 

Different Types of ETFs Explained

Given that ETFs are composed of a conglomerate of stocks, there are several different functions that an ETF seeks to achieve. Funds incorporate distinct forms of stock to accomplish different objectives: these are called asset classes.

Some asset classes focus on aggressive growth by utilizing more volatile stock plays. Other asset classes intend to incur consistent returns by using stocks that fluctuate with- or mimic- the market. In essence, there are several types of ETFs.

Stock ETFs

These funds contain various traditional equity stocks. Investing in a stock ETF can be inherently less precarious than investing in individual equity stocks. However, Stock ETFs are riskier than other funds encompassing less risky investments, such as bonds or commodities.

Commodity ETFs

Commodity stocks are those that represent raw materials used in the production of various products. Commodity stocks can include gold, coal, oil, or any other typical commodity. You may find this form of ETF enticing if you have an impregnable understanding of any particular commodity industry.

Bond ETFs

Bonds protect your investment with collateral. Investors utilize them for consistent forms of expected/fixed income. Bond ETFs are considered low risk and are often used in a complementary manner with riskier investments. 

International ETFs

Foreign investments can be key for the diversification of a portfolio. Hedging risk by allocating investments to several international economies is a common tactic for investors. These types of ETFs prevent you from succumbing to the performance of a single nation’s economic performance. 

There are also global ETFs, which combine domestic equity stocks with foreign ones. International/global stocks are also available for individual industries (international tech ETFs for example).

Sector ETFs

There are eleven sectors of investment. The ETF that represents each sector is composed of organizations that operate in said sector. For example, a financial sector ETF will comprise economic institutions such as banks or financial advisory firms. 

Sector ETFs provide investment options for emerging sectors as well. If you knew a boom in technological investment was imminent, it would be wise to purchase a sector ETF composed of tech stocks. 

Comparison of ETFs With Other Types of Investments

ETFs have many similarities to and differences from investments in traditional equity stocks and mutual funds. Below is a more detailed outline of each form of investment and the qualities that differentiate them.

ETFs vs Individual Equity Stocks

When purchasing an ETF, you may ask why you should not simply buy every stock within the ETF and manage it yourself to avoid commission fees. Typically, ETFs do not disclose every company within them, making it impossible to purchase each of the stocks individually. Also, these transactions are carefully analyzed by a trained professional. You may find that entrusting a financial professional with a portfolio is worth the burden of paying an extra commission fee. 

Both forms of investment come from companies listed on a stock exchange. As mentioned above, ETFs also protect you from the lack of diversification. The more diversified an account is, the less likely you are to lose the capital you invest into your portfolio. Buying stocks directly leaves you at risk of having an undiversified portfolio.

ETFs vs Mutual Funds

ETFs and mutual funds both offer diversified portfolios. However, ETFs sell the stake in a fund in a more convenient manner. 

ETFs also omit costly commission fees often associated with mutual funds. Though ETFs commonly require small commission fees, it is uncommon for them to be more expensive than the fees associated with mutual funds. Since mutual fund managers overlook the fund more closely than an ETF manager, there is higher turnover, meaning more transactions take place in a mutual fund. Because these transactions incur taxation, more taxes are paid on mutual funds than on ETFs.

Index funds intend to mimic the movements of the stock market by following a market index, and they are available to owners of both mutual and exchange-traded funds. ETFs intending to mimic the market will be more tax-efficient than their mutual fund counterpart. Assuming they both maintain the same net asset value and reach similar benchmarks in terms of growth, ETFs are typically more cost-effective. 

However, if you are willing to incur the additional tax to forgo tracking your own funds, you may choose to invest in mutual funds. Furthermore, if you are a new investor who is unfamiliar with the stock market, you may prefer mutual funds over ETFs as well.

👉 Read next: What Is an Inverse ETF?

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