What is ETF? Meaning, function and why you need it
The first exchange-traded fund (ETF) was launched in 1993.
Fast forward to date, and the global ETF assets stand at a whopping $9.1 trillion.
In 2020 alone, investors poured more than $730 billion into ETFs.
So what makes ETFs so popular among investors?
Exchange-traded fund (ETF)
Exchange-traded funds (ETFs) are tradable securities that track an index, commodity, sector, currency, or other assets. They are called exchange-traded funds, as they are traded on the stock exchange, just like stocks. And that allows investors to buy and sell ETFs, like stocks.
To understand ETFs better, imagine you’re grocery shopping. Now, you can either fill your basket with the essentials by walking down the aisles of the supermarket, finding each of the items, and adding it to your basket. Or you can simply buy one of those pre-filled baskets that have all the essential groceries.
ETFs are just like these pre-filled baskets, but for stocks. And unlike mutual funds, ETF shares can be bought and sold using your brokerage account, just like you would do with stocks.
ETFs can be structured to track anything from the price of a commodity to a collection of tradable securities. To do this, the fund will own the assets it is supposed to track. When it comes to tracking indexes, ETFs work almost the same way, as a low-cost index fund.
For example, if an ETF needs to track the performance of the S&P 500, the fund will buy stocks of all the companies in the S&P 500 and allocate them accordingly. So if you buy a share of this particular ETF, you’ll have invested in all the companies in S&P 500.
ETFs can have hundreds of assets in their holdings, to track stocks across various industries. Or it can focus on a particular industry or sector.
A very popular exchange-traded fund in the US is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.
The popularity of Exchange-traded funds
As you can tell from the chart, the popularity of ETFs has risen rapidly over the years.
So what makes ETFs so popular?
Ease of use
ETFs are especially popular among newer investors. Most of them would start with a broad market ETF like SPY rather than picking individual stocks.
Why? It’s an easy choice.
Having to go through each individual stock deciding whether it’s the right choice for them, is intimidating to most newer investors. Whereas with ETFs, you’re instantly investing your money in the largest companies in the market.
ETFs trade on exchanges with ticker symbols similar to stocks. That makes it really easy to find them with a brokerage account.
Investing in ETFs brings in immediate diversification.
As we’ve discussed earlier, ETFs are a basket of stocks. So buying a single ETF share will ensure that you’re investing in multiple companies. And if it is a broad market ETF, your investment will be spread across companies in different sectors and industries. That helps in decreasing volatility.
Because it’s highly unlikely that companies across all sectors will go down at the same time.
Also, for someone who picks individual stocks, ETFs can help in getting exposure to a certain sector, they might not be familiar with. For example, if you believe that the marijuana industry has significant room for growth, but you’re not quite sure which company to pick, choosing an ETF that focuses on marijuana stocks can save you time, and still make sure you don’t miss out on the industry winners.
Another advantage of ETFs is that you don’t need to frequently intervene with your assets. You can invest your money in a broad market ETF and forget all about it, and still grow your portfolio.
In many instances, these constant interventions and changes are the reason people lose money in the markets.
And the fund itself is passively managed. Meaning ETFs are generally automated to imitate changes in the underlying index/asset it tracks. Often, that results in having almost the same performance as that of the underlying index.
Having said that, there are also actively managed ETFs. These are run by professionals who make changes to the fund’s holdings more often. As a result, the fees tend to be higher when compared to passive ETFs. ARK Innovation ETF (ARKK) is an example of an actively managed ETF.
In general, most ETFs tend to be passively managed.
Low cost and commissions
This is a major factor in the wide popularity of ETFs. It’s cheap to invest in them.
The thing with investment vehicles is that they’ll charge you a substantial amount, for allowing you to invest in them. Actively managed mutual funds, for example, charge anywhere from 0.5% – 2% of your investment, annually.
But not ETFs.
On average, ETFs tend to charge anywhere between 0.02% – 0.75%.
You might wonder why we’re fretting over such a small percentage difference. After all, mutual funds are managed by finance professionals – they must know what they’re doing.
Well, think again.
A study by Vanguard found that only 18% of active mutual fund managers beat their benchmarks over a 15-year period. And, of these outperforming managers, 97% of them experienced at least five years of underperformance.
So basically, when choosing to invest in a mutual fund, you’re paying them huge sums of money every year, only to underperform the market.
With ETFs however, that’s not the case.
Sure, you might not beat the market. But you’ll likely match its performance every year. And believe me, you’ll be far ahead of most investors out there.
Different types of ETFs
As I said, there are ETFs for almost every asset, sector, and industry. Let’s look at some popular types.
These are baskets of stocks that focus on a specific industry or sector. This also includes broad market ETFs such as SPY, which tracks the S&P 500, thereby tracking the performance of the 500 largest companies in the US. As illustrated before, stock ETFs have lower fees when compared to stock mutual funds.
These ETFs are also stock-based. However, industry ETFs focus on a particular industry or sector (known as sector ETFs) rather than the broad market. This helps investors in getting exposure to an industry, which they might not be familiar. Especially with high-growth industries like technology, investors might be confused as to where they should invest.
So instead of looking for a specific company, they can invest in an ETF that focuses on major technology companies out there, making sure they don’t miss out.
It’s what the name says – an ETF for bonds. Bond ETFs hold various kinds of bonds such as treasury bonds, corporate bonds, and municipal bonds. Their income distribution depends on the performance of their underlying assets. Investors generally choose bond ETFs, when they are looking for regular income from their investments.
These ETFs track the price of a commodity like gold or crude oil. These funds can be used to hedge your portfolio from downturns in the stock market. It is also far better than owning the physical commodity, as it involves a lot of complications. Commodity ETFs invest in all kinds of commodities.
For example, the popular coffee ETF in the US is iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO).
This is a different kind of ETF. While most funds are trying to capitalize on the price appreciation of underlying assets, inverse ETFs do the quite opposite. They aim to earn gains when the underlying asset goes down. This is done using something called shorting.
ETFs vs Stocks
ETFs and stocks are inseparably linked.
ETFs have lots of similarities with stocks; how they can be bought and sold, ticker symbols, etc. More importantly, the majority of the ETFs are made of stocks.
As for which of these is the better investment choice, I would say that’s entirely up to you.
ETFs can be helpful if you’re a complete beginner and don’t know where to start. Or if you do not have the time to spend picking individual stocks, ETFs might be the ideal choice for you.
You may also choose ETFs as a way of getting exposure to industries that are unfamiliar to you. Thereby enhancing your portfolio and ensuring diversification.
ETFs vs Mutual Funds
To iterate what we have discussed before, ETFs have several advantages over mutual funds.
ETFs are certainly cheaper. On average you’ll be charged anywhere between $75-$200 a year, for every $10,000 you invest in mutual funds. Whereas in ETFs, you’ll only be charged $2 – $20 a year, for the same investment.
This is because mutual funds are actively managed by a finance professional who is constantly in the pursuit of beating the market. Yet, over the past 15 years, only 1 in 13 managers have succeeded in doing so.
And ETFs are more tax-efficient than mutual funds.
Generally, when you sell shares and realize the gains, you’ll incur capital gains taxes, which will be taxed depending on how long you’ve held the assets.
ETFs are passively managed. So buying and selling within the fund is less. However, as mutual funds are actively managed there are more buying and selling shares. This can incur taxes.
This means, even if you don’t sell any mutual fund shares, you might still incur taxes due to the nature of how mutual funds work.
ETFs are your go-to choice if you are a complete beginner, or if you don’t have the time to do due diligence in individual stocks. ETFs allow you to get started with investing. And for someone who has a portfolio of individual stocks, it helps you in diversifying your assets and getting exposure to different sectors.
However, it is important to know that your returns will be average. You might never beat the market.
But if you can put aside 20 mins a day, you could potentially generate substantial returns and beat the market year over year, by choosing individual stocks.
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