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What Is an Exchange Traded Fund (ETF)?


An exchange-traded fund (ETF) is a form of security that tracks an index, sector, commodity, or other asset and may be bought and sold on a stock exchange like any other stock. An ETF can be set up to track anything from a single commodity's price to a big and diverse group of securities. ETFs can even be built to follow certain investment strategies.

 
 
TABLE OF CONTENTS
  • What Is an ETF?
  • Types of ETFs
  • How to Begin Investing in ETFs
  • How to Buy and Sell ETFs
  • Real-World Examples of ETFs
  • Advantages and Disadvantages of ETFs
  • ETF Creation and Redemption
  • ETFs Vs Mutual Funds Vs Stocks

 

 

The SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, is a well-known example. ETFs can hold a variety of investments, such as stocks, commodities, bonds, or a combination of them. An exchange-traded fund is marketable security, which means it has a price that can be purchased and sold easily.

 

TAKEAWAYS


An exchange-traded fund (ETF) is a collection of securities that trade like stocks on a stock exchange.
Unlike mutual funds, which only trade once a day after the market closes, ETF share prices fluctuate throughout the day as the ETF is purchased and sold.


ETFs can hold a variety of assets, including equities, commodities, and bonds; some are limited to holdings in the United States, while others are global.


When compared to buying equities separately, ETFs have lower expense ratios and lower broker commissions.
Because it trades on an exchange like stocks, an ETF is termed an exchange-traded fund. As shares are purchased and sold on the market, the price of an ETF's shares will fluctuate during the trading day. Mutual funds, on the other hand, are not traded on a stock exchange and only trade once a day after the markets shut. Furthermore, as compared to mutual funds, ETFs are more cost-effective and liquid.


An ETF, like a stock, is a type of investment that holds numerous underlying assets rather than just one. ETFs are a popular alternative for diversification because they contain a variety of assets.

An ETF can own hundreds or thousands of equities from a variety of industries, or it can be focused on a single area or industry. Some funds are only focused on the United States, while others have a global vision. Banking-focused ETFs, for example, would hold stocks from a variety of banks across the industry.

 

ETFs come in a variety of shapes and sizes.


Investors can choose from a variety of ETFs that can be used to generate income, speculate on price gains, and hedge or partially offset risk in their portfolios. Here's a quick rundown of some of the most popular ETFs on the market right now.

 

ETFs that invest in bonds

Bond ETFs are utilized to offer investors a steady stream of income. The distribution of their earnings is determined by the performance of the underlying bonds. Government bonds, corporate bonds, and state and local bonds, often known as municipal bonds, are examples. Bond ETFs, unlike their underlying assets, do not have a set maturity date. They usually trade at a premium or a discount to the price of the underlying bond. More information on bond ETFs can be found here.

 

ETFs that invest in stocks

Stock ETFs are a collection of stocks that track a specific industry or sector. A stock ETF might, for example, track automotive or international stocks. The goal is to deliver a diverse experience to a single industry, one that comprises elite performers as well as newcomers with growth potential. Stock ETFs, unlike stock mutual funds, have cheaper costs and do not require actual stock ownership. More information about stock ETFs can be found here.

 

ETFs that track specific industries

ETFs that focus on a single industry or sector is known as industry or sector ETFs. Companies operating in the energy industry, for example, will be included in an energy sector ETF. The goal of industry ETFs is to obtain exposure to an industry's upside by monitoring the performance of companies in that area. One recent example is the IT sector, which has seen an influx of capital. On the same hand, because ETFs do not involve direct ownership of shares, the downside of erratic stock performance is also limited. During economic cycles, industry ETFs are also utilized to move in and out of sectors. More information on sector ETFs can be found here.

 

ETFs that invest in commodities

Commodity ETFs, as their name suggests, invest in commodities such as crude oil or gold. Commodity ETFs have a number of advantages. They first diversify a portfolio, making it easier to hedge against market downturns. Commodity ETFs, for example, can act as a safety net in the event of a stock market downturn. Second, owning shares in a commodity ETF is less expensive than owning the commodity itself. This is due to the fact that the former does not require insurance or storage. More information on commodity ETFs can be found here.

 

ETFs that invest in currencies

Currency exchange-traded funds (ETFs) are pooled investment vehicles that monitor the performance of currency pairs that include both domestic and foreign currencies. Currency exchange-traded funds (ETFs) have a variety of uses. They can be used to speculate on currency prices based on a country's political and economic trends. Importers and exporters use them to diversify their portfolios or as a hedge against volatility in the FX markets. Some of them are also employed as a form of inflation protection. More information on currency ETFs can be found here.

 

ETFs that trade in the opposite direction of the market

By shorting equities, inverse ETFs try to profit from stock falls. Shorting is the act of selling stock and then repurchasing it at a cheaper price, anticipating a price drop. To short a stock, an inverse ETF employs derivatives. They are, in essence, wagers on the market's downfall. When the market falls, the value of an inverse ETF rises proportionately. Many inverse ETFs are exchange-traded notes (ETNs), not actual ETFs, as investors should be aware. An ETN is similar to a bond, but it trades like a stock and is backed by a bank. If you're not sure if an ETN is good for your portfolio, talk to your broker.

 

Most ETFs are set up as open-ended funds in the United States and are governed by the Investment Company Act of 1940, unless subsequent rules have changed their regulatory requirements. The number of investors who can participate in an open-end fund is unrestricted.

 

How to Get Started with ETF Investing


Investing in ETFs has become very simple because of the several platforms available to traders. To begin investing in ETFs, follow the procedures listed below.

 

ETFs are available on most online investment platforms, retirement account providers' websites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, which means you won't have to pay any costs to purchase or sell ETFs. A commission-free charge purchase or sale, on the other hand, does not imply that the ETF provider would also provide access to their product at no cost. Platform services can differentiate themselves from one another in terms of convenience, services, and product variety. Smartphone investing apps, for example, make it possible to buy ETF shares with a single click. This may not be the case with all brokerages, which may require documentation or a more difficult situation from investors. However, several well-known brokerages provide comprehensive educational content to help new investors learn about and research ETFs.


Examine ETFs: The second, and most crucial, step in ETF investing is to conduct research. Today's markets provide a wide range of exchange-traded funds (ETFs). One thing to keep in mind during your study is that ETFs are not the same as individual instruments such as stocks or bonds. When investing in an ETF, you must analyze the big picture - in terms of sector or industry. Here are some questions you might want to think about when you conduct your research:


Do you have any favorite industries or financial instruments?


Consider the following trading strategy: Dollar-cost averaging, or spreading out your investment fees over a period of time, is a smart trading approach for new ETF investors. This is due to the fact that it smooths out returns over time and ensures a disciplined (rather than haphazard or erratic) approach to investment. It also assists novice investors in better understanding the subtleties of ETF investment. Investors can progress to more complicated tactics like swing trading and sector rotation as they gain experience in trading.
ETFs can be purchased and sold through both online brokers and traditional broker-dealers. With Investopedia's list of the best ETF brokers, you can see some of the greatest brokers in the market. Robo-advisors like Betterment and Wealthfront, which use ETFs in their investment products, offer an alternative to traditional brokers.


Examples of ETFs in the Real World


The following are some of the most popular ETFs on the market today. Some ETFs monitor a stock index to create a broad portfolio, while others focus on a single industry.

 

The SPDR S&P 500 (SPY) is the most well-known and oldest ETF that tracks the S&P 500 Index.
The Russell 2000 small-cap index is tracked by the iShares Russell 2000 (IWM).
The Nasdaq 100 is represented by the Invesco QQQ (QQQ) index, which typically features technology stocks.
The Dow Jones Industrial Average (DIA) is represented by the SPDR Dow Jones Industrial Average (DIA).
Individual industries are tracked via sector ETFs such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), and biotech (BIO) (BBH).
Commodity exchange-traded funds (ETFs) track commodity markets such as crude oil (USO) and natural gas (NGA) (UNG).
Physically-Backed ETFs: The SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV) are both physically-backed ETFs that hold physical gold and silver bullion.


ETF Benefits and Drawbacks ETFs offer reduced average costs because buying all of the stocks in an ETF portfolio individually would be prohibitively expensive. Because investors only make a few trades, they only need to complete one transaction to buy and one transaction to sell, resulting in lower broker commissions. Each trade is usually charged a commission by the broker. Some brokers even provide no-commission trading on some low-cost ETFs, significantly lowering investor costs.

 

The expense ratio of an ETF is the cost of operating and managing the fund. Because they mirror an index, ETFs often have low expenses. If an ETF tracks the S&P 500 index, for example, it may hold all 500 equities in the index, making it a passively managed fund with less time commitment. Not all ETFs, however, follow an index in a passive manner.

 

Pros: You have access to a wide range of stocks from a variety of industries.

Expense ratios are low, and broker commissions are low.

Diversification helps to manage risk.

There are ETFs that specialize in specific industries.

Fees for actively managed ETFs are higher.

ETFs with a single industry emphasis reduces diversity.

Transactions are hampered by a lack of liquidity.

 

ETFs that are actively managed


There are also actively managed ETFs, which include portfolio managers that are more involved in buying and selling stocks and modifying the fund's holdings. A more actively managed fund will often have a higher expense ratio than an ETF that is passively managed. To assess whether a fund is worth holding, investors should look at how it is managed, whether it is actively or passively managed, the resulting expense ratio, and weigh the costs vs the rate of return.


ETFs that track indexes of stocks


Because there are no minimum deposit requirements, an indexed-stock ETF gives investors the diversification of an index fund as well as the option to sell short, buy on leverage, and buy as few as one share. Not all ETFs, however, are equally diversified. Some may have a high concentration in a single industry, a small number of equities, or assets that are closely connected.

 

ETFs and dividends


While ETFs allow investors to profit from rising and falling stock prices, they also benefit from companies that pay dividends. Dividends are a portion of a company's earnings that is allocated or paid to investors in exchange for holding their stock. ETF shareholders are entitled to a percentage of the fund's gains, such as interest received or dividends paid, as well as a residual value in the event the fund is liquidated.

 

Taxes and ETFs
Because most buying and selling occurs through an exchange, an ETF is more tax-efficient than a mutual fund because the ETF sponsor does not have to redeem shares each time an investor chooses to sell or issue new shares each time an investor desires to acquire. Because redeeming a fund's shares can result in a tax burden, listing the shares on an exchange can help keep tax costs down. When an investor sells their shares in a mutual fund, the fund sells them back to the investor, resulting in a tax burden that must be paid by the fund's shareholders.

 

Market Impact of ETFs
Many new funds have been launched as ETFs have grown in popularity among investors, resulting in low trading volumes for some of them. As a result, investors may find it difficult to buy and sell shares of a low-volume ETF.

Concerns have been raised concerning ETFs' impact on the market and whether their popularity can inflate stock prices and cause fragile bubbles. Some ETFs use portfolio models that haven't been validated in varied market conditions, which might result in large inflows and outflows from the funds, putting market stability at risk.

Since the financial crisis, ETFs have played a significant role in market volatility and flash crashes. ETF issues had a major role in the flash crashes and market drops that occurred in May 2010, August 2015, and February 2018.


The Creation and Redemption of Exchange-Traded Funds (ETFs)
The creation and redemption system, which involves large specialized investors known as authorized participants, regulates the supply of ETF shares (APs).

 

ETF Development
When an ETF wants to issue more shares, the AP buys shares of the equities in the fund's index—such as the S&P 500—and sells or exchanges them for new ETF shares of equal value. As a result, the AP profitably sells ETF shares on the open market. The act of an AP selling equities to an ETF sponsor in exchange for ETF shares is referred to as creation.

 

When a company's stock trades at a premium, it's called creation.
Consider an ETF that invests in S&P 500 equities and has a share price of $101 at market closing. If the stock value of the ETF's holdings were only worth $100 a share, the fund's price of $101 would be trading at a premium to its net asset value (NAV). The NAV is a calculation that determines the entire value of an ETF's assets or equities.

 

An authorized participant has an incentive to bring the ETF share price and the fund's NAV back into balance. To accomplish so, the AP will purchase from the market shares of the equities that the ETF intends to hold in its portfolio and sell them to the fund in exchange for ETF shares. In this case, the AP is purchasing stock on the open market for $100 per share while also purchasing shares of an ETF on the open market for $101 per share. This is known as creation, and it increases the amount of ETF shares available on the market. If all other factors stay constant, increasing the number of shares available on the market will lower the ETF's price and bring shares closer to the fund's NAV.

 

Redemption of an ETF
An AP, on the other hand, purchases ETF shares on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares, which he or she can subsequently sell on the open market. As a result, through a procedure known as redemption, the number of ETF shares is lowered.

 

Demand in the market and whether the ETF is trading at a discount or premium to the value of the fund's assets determine the amount of redemption and creation activity.

 

When Shares Trade at a Discount, Redemption
Consider an ETF that owns the Russell 2000 small-cap index and is now priced at $99 a share. The ETF is trading at a discount to NAV if the value of the stocks it holds in the fund is worth $100 per share.

 

An AP will buy shares of the ETF on the open market and sell them back to the ETF in exchange for shares of the underlying stock portfolio to restore the ETF's share price back to its NAV. In this case, the AP is able to purchase $100 worth of stock in exchange for $99 worth of ETF shares. This is known as redemption, and it reduces the number of ETF shares available on the market. When the supply of ETF shares is reduced, the price of the ETF should climb and approach its NAV.

 


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