What Is an ETF?
An ETF or “exchange-traded fund” is an investment fund traded on stock exchanges, much like stocks.
Typically, an ETF holds assets such as commodities, stocks or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occur.
ETF = ‘Exchange-traded fund’
An exchange-traded fund, more commonly referred to as an “ETF” — is a fund that can be traded on an exchange like a stock (hence the name). ETFs provide a way to buy and sell a “basket” of assets without having to buy all the components .
How an ETF works: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. The shareholders will own a portion of the ETF, but they do not own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index will receive lump dividend payments, or reinvestments, for the stocks that make up the index.
Whilst ETF’s are designed to track the value of an underlying asset — be it a commodity like gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.
Key ETF Points
- An exchange-traded fund (ETF) is a “basket” of securities that trade on an exchange, just like a stock.
- ETF share prices fluctuate all day as the ETF is bought and sold; whereas mutual funds that only trade once a day after the market closes.
- ETF’s can contain all types of investments including stocks, commodities, or bonds; some offer U.S. only holdings, while others are international.
- ETF’s offer low expense ratios and fewer broker commissions than buying the stocks individually.
So, let’s break it down – How ETF’s work, in 3 simple steps
- An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them, with a unique ticker.
- Investors can buy a share of that basket, just like buying shares of a company.
- Buyers and sellers trade the ETF throughout the day on an exchange, much like a stock.
ETFs vs. mutual funds vs. stocks
Generally speaking, ETF’s have lower fees than mutual funds — and this is a big part of their appeal. Whereas the average U.S. equity mutual fund charges 1.42% in annual administrative expenses, “an expense ratio” . The fees on the average equity ETF are 0.53%, according to data from ETF.com, a subsidiary of the Chicago Board Options Exchange that’s dedicated to these investments.
Tax Efficiency – ETF’s also offer tax-efficiency advantages to investors and there is generally more turnover within a mutual fund (especially those that are actively managed) relative to an ETF, and such buying and selling can result in capital gains. Similarly, when investors go to sell a mutual fund, the manager will need to raise cash by selling securities, which also can accrue capital gains. In either scenario, investors will be on the hook for those taxes.
ETF’s are increasingly popular, (read our article on Financial Maturity) but the number of available mutual funds still is higher. The two products also have different management structures (typically active for mutual funds, passive for ETFs).
Like stocks, ETF’s can be traded on exchanges and have unique ticker symbols that let you track their price activity. There’s “SPY” for one of the ETF’s that track the S&P 500, and fun ones like “HACK” for a cyber-security fund and “FONE” for an ETF focused on smart phones. That’s where the similarities end, however, because ETFs represent a basket of assets, whereas a stock represents just one company.
Pros and cons of ETFs
In 2018, U.S. investors had $3.4 trillion invested in ETF’s — more than double the cash invested in ETF’s in 2013, according to the Investment Company Institute. Investors have flocked to ETFs because of their simplicity, relative cheapness and access to a diversified product.
At a Glance – Cash Invested in ETFs
The dollar amount, in trillions, invested in exchange-traded funds worldwide
The Pros of ETF investment
- Diversification:While it’s easy to think of diversification in the sense of the broad market verticals such as — stocks, bonds or a particular commodity. ETF’s also allow the investor to diversify across horizontals, like industries. It would require a lot of money and effort to buy all the components of a particular basket, but with the click of a button, an ETF delivers those benefits to your portfolio.
- Transparency:Anyone with internet access can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds.
- Tax benefits:Investors typically are taxed only upon selling the investment, whereas mutual funds incur such burdens over the course of the investment.
The Cons of ETF investment
- Trading costs:ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.
- Any buyers for the ETF?As with any security, you’ll be at the whim of the current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.
- Risk the ETF will close:The primary reason this happens is that a fund hasn’t brought in enough assets to cover administrative costs. The biggest inconvenience of a shuttered ETF is that investors must sell sooner than they may have intended — and possibly at a loss. There’s also the annoyance of having to reinvest that money and the potential for an unexpected tax burden.
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