Understanding Exchange Traded Funds
An increasing number of investors have been utilizing exchange-traded funds (ETFs) to come up with diverse portfolios. However, before choosing to invest in an ETF, it is always good practice to read its summary and full prospectus. This will provide you with all the detailed information you need to know about the ETF’s investment objective, risks, costs, historical performance, and principal investment strategies.
Investing in something you know little about can turn out to be a risky venture. Luckily for you, however, the sages at MoneyWizard.co have summed up all the pertinent details to help you understand ETFs. Click through to read more about this type of investment.
What Is an ETF?
An ETF is a basket of securities such as stocks, bonds, commodities, or foreign currency that you can purchase or sell using a brokerage firm on a stock exchange market. It allows you to build a diverse investment portfolio, which in return earns you interest. ETFs must be registered with the US Securities and Exchange Commission as provided for under the Investment Company Act of 1940, either as an open-end investment company called “funds” or as a unit investment trust.
Just like ordinary stocks, an ETF trades throughout the day at fluctuating prices. In most cases, ETFs track indexes such as NASDAQ, Dow Jones, S&P 500, and Russell 2000. Investors in ETFs have no direct ownership of the underlying investments. Rather, their claim of the investment is indirect, and they are entitled to a portion of the profits and residual value should the fund be liquidated. The shares or interests they own can easily be bought and sold in the secondary market.
ETFs don’t directly sell or redeem individual shares from retail investors. Instead, ETF sponsors establish contracts with one or more financial institutions that are usually referred to as “authorized participants.” These authorized participants are large-scale broker-dealers who are allowed to buy and redeem shares directly from an ETF. They can buy or redeem in large aggregations such as 50,000 ETF shares, which are commonly referred to as “creation units.”
ETFs vs Mutual Funds vs Stocks
ETFs exhibit some of the characteristics of mutual funds. However, they are different from mutual funds in many respects. For instance, an ETF can be bought or redeemed at the close of every trading day at its net asset value (NAV) per share. This usually involves the intraday trading feature of a closed-end fund whose shares trade throughout the day at market prices.
Unlike mutual fund shares, ETFs offer investors high tax efficiency. This is because turnover within a mutual fund is generally higher, especially for those that are actively managed. High buying and selling turnover can bring about capital gains. At the same time, should investors choose to sell a mutual fund, the manager may need to raise cash through the sale of securities, which may equally accrue capital gains. This makes investors prone to taxation costs.
Both stocks and ETFs trade on exchanges and have distinct ticker symbols that allow you to track how their prices are playing out. For example, SPY for ETF tracks the S&P 500, while FONE for ETF focuses on smartphones. The significant difference is that ETFs are a basket of assets, while a stock represents only one company. Considering this, ETFs can help you hedge risks that are associated with individual companies, as they allow you to get involved with an industry or an entire index with a single investment.
Types of ETFs
There is a diverse range of ETFs, and each of them has a different investment focus. In the US, the existing types of ETFs include:
1. Stock ETFs
Stock ETFs hold a specific portfolio of equities or stocks and are very similar to an index. They can be considered regular stocks, as they can be sold and bought for a profit and are traded on the exchange market throughout the trading day.
2. Bond ETFs
A bond ETF is specifically invested in bonds or other fixed-income securities. They may focus on a particular type of bond or offer a broadly diversified portfolio of bonds with varying maturity dates.
3. Index ETFs
Index ETFs generally mimic a specific index, such as the Dow Jones. They can cut across specific sectors, specific categories of stocks, or foreign or emerging market equities.
4. Currency ETFs
Currency ETFs are invested in one currency or a basket of diverse currencies. They are mainly utilized by investors who want to gain exposure to the foreign exchange market but don’t want to trade directly in the forex market. These ETFs typically track the most popular global currencies, such as the US dollar, the Euro, the Japanese yen, the Canadian dollar, and the British pound.
5. Commodity ETFs
Commodity ETFs hold physical commodities such as agricultural goods, natural resources, and precious metals. Others may hold several investments combined in a physical commodity together with similar equity investments. For instance, a gold ETF can have a portfolio that is a combination of physical gold and stock shares in gold mining companies. Other ETF types include inverse, actively managed, leveraged, and real estate ETFs.
How ETFs Work
The working principles of an ETF are simple:
- The fund provider designs a fund to track the performance of a universe of assets. These assets include stocks, bonds, currencies, and commodities.
- The ETF provider then creates a basket of the assets with a unique ticker and sells them to investors, which will trade throughout the day in the exchange market.
- The shareholders will own a portion of the ETF, but not the underlying assets in the fund. Investors in the ETF get reinvestments or lump dividend payments for the stocks that make up the index.
Pros and Cons of ETFs
Investing in ETFs has both advantages and disadvantages, but the advantages far outweigh the disadvantages.
Pros of ETF investment
1. Low expense ratios
The transaction costs and fees in ETFs are generally lower. This is because their exchange-traded nature places typical costs on the brokers or the exchange as compared to mutual funds, which have to carry the burden of the cost in aggregate.
2. Market accessibility
ETFs enable exposure to asset classes that were previously difficult for individual retail investors to access. These classes include emerging market equities and bonds, gold bullion, and cryptocurrencies. Since ETFs can be sold short and margined or leveraged, they open up opportunities for the utilization of sophisticated trading strategies.
3. Transparency
Unlike hedge and mutual funds, the operations of ETFs are transparent. They disclose their daily portfolios, which makes the investor aware of the exact manner in which their money is being invested. This is in contrast to hedge and mutual funds whose disclosures are done quarterly, leaving investors in suspense as to how their money is being invested.
4. Liquidity and price discovery
ETFs are more liquid, as they can be bought or sold in secondary markets throughout a trading day. Typically, they trade close to their actual NAV. Their mechanism of creation or redemption continually balances out the arbitrages in pricing. This always helps to bring the price of ETF shares back to fair market value.
5. Tax efficiency
In an after-tax context, ETFs have a big advantage over mutual funds. They reduce portfolio turnover and make it possible for you to avoid short-term capital gains that involve high tax rates through in-kind redemptions. Additionally, ETFs are able to overcome rules prohibiting the sale and claim of a loss on security should similar securities be purchased within a 30-day window.
Cons of ETF investment
1. Trading costs
Since ETFs are exchange-traded, they may fetch commission fees from online brokers. While the majority of brokers have done away with their ETF commissions, some have not.
2. Risk of closure of the ETF
If the ETF doesn’t bring in enough assets to cover administrative costs, then it may be closed. When an ETF closes, investors are forced to sell sooner than they may have intended, and typically at a loss. This carries the additional disadvantage of the investor having to reinvest that money, which may result in an unexpected tax burden.
Frequently Asked Questions
Why an ETF instead of individual stock bonds?
A stock is a portion or shares that you own in a specific company. An ETF, on the other hand, is a collection of individual stocks, bonds, and other types of investments pooled together. It is this difference that makes ETFs a better investment.
Weighing between the risk and the potential return, an individual stock holds a higher risk as an investment. This is due to the potential for wide price swings and the likelihood of large losses should things go south for the company. ETFs, on the other hand, are low-risk investments. When you invest in ETFs, you are investing in dozens—sometimes even hundreds—of companies, most of which have considerable built-in diversification. As such, should one stock perform poorly, it can be offset by any of the other better-performing stocks in the basket.
Why an individual stock instead of a mutual fund?
Buying an individual stock or mutual fund boils down to personal preferences. It pays off to consider the pros and cons of each investment before venturing into it. With proper guidance from an investment advisor such as MoneyWizard.co, you can identify individual stocks that are responsive to your desired risk level and financial goals.
With an individualized approach, you can better diversify your portfolio and give yourself greater flexibility in controlling when and where the investment is made. Mutual funds also carry the advantage of easy diversification, the avoidance of trade costs, convenience, and reduced time intensity.
How can I buy an ETF?
There are various methods that you can use to invest in ETFs. How you do it will be based mainly on personal preference. For seasoned investors, the process is easy. One way is through online brokers and traditional broker-dealers. The number of offerings may vary from one broker to another. It can also be done through robo-advisors, who construct their portfolio from low-cost ETFs. This gives investors who are new to ETFs access to the assets.
Do ETFs pay dividends?
ETFs typically make payments for full dividends generated by stocks held within the fund. Most make their dividends pay out on a quarterly basis by holding all the dividends paid by underlying stocks in the course of the quarter, and then making payments to shareholders on a pro-rata basis. Payment may be in the form of cash or made through an offer of reinvestment in additional shares.
Dividends are calculated according to the percentage of shares an investor owns in a company multiplied by the amount of dividends paid per quarter for all the dividend-paying stocks. For instance, if an ETF has 200 shares, and the investor owns 20 shares of that ETF, the investor owns the right to 10% of the total dividends that the ETF earns. If ten of those ETFs were dividend-paying stocks, each with a quarterly dividend of one dollar, and the ETF owned 20 shares of each dividend-paying stock, the ETF would earn $200 per quarter.
Are ETFs safer than stocks?
ETFs, just like stocks, carry a risk. Even though they are deemed safer investments, some may offer more than average gains, while investors may not see returns on others. It is all dependent on the sector or industry that the fund is tracking and the diversity of the stocks in the fund. Even so, stocks are volatile as per the economy, global circumstances, and the state of the stock-issuing company.
Whether ETFs or stocks, both carry a certain level of risk based on the basket of assets put into the fund and the risk that those assets carry. Both also have fees and fetch a tax, and your tolerance for risk can be a key determinant for which of the two best fits your financial goals.
Do you have to pay taxes on ETFs?
The dividends and interest payments you receive from ETFs are taxed the same way as income from the underlying stocks or bonds, with the income reported on your 1099 statement. Also, profits on ETFs sold at a gain fetch tax, just like the underlying stocks or bonds. ETFs held for over one year are taxed as per the long-term capital gains rates—typically up to 23.8%, inclusive of the 3.8% net investment income tax. ETFs held for less than a year fetch tax at the ordinary income rate—up to 40.8%.
Conclusion
What works for one investor might not work for another. Therefore, before you invest in an ETF, check out all the details in both its summary and its full prospectus. It is not prudent to invest in what you don’t understand. Consider seeking the advice of a well-informed investment professional who understands your investment objectives, your risk tolerance, and the list of complex products in the market. At MoneyWizard.co, we will explain to you if and how an ETF would be a good fit for you.
