Exchange-Traded Fund

Why should I care about ETFs?

For markets: ETFs are pivotal in modern trading environments, providing instant access and diversified exposure to a variety of assets, sectors, or geographical regions in a single transaction. They enhance market liquidity, making it easier for both retail and institutional investors to buy and sell without causing major price fluctuations.

For you personally: Whether you're a novice looking to get started in investing or a seasoned trader seeking to hedge risks, ETFs offer an accessible way to invest. They tend to be what robo-advisors and other firms use to create low-cost investment portfolios for you, so they’re worth knowing about even if you plan to be a very hands-off investor.

How do ETFs work?

ETFs operate through a unique mechanism involving authorized participants (APs) – usually large financial institutions – responsible for creating and redeeming ETF shares. Here's how it works:

• Creation of shares: When demand for an ETF increases, APs buy the underlying assets of the ETF (i.e stocks or bonds) and deliver them to the ETF issuer. In return, the AP receives ETF shares, called “creation units”.
• Trading: These shares are then broken down into smaller units and traded on stock exchanges, similar to individual stocks. This allows investors to buy and sell ETF shares throughout the trading day at market prices.
• Redemption: If the number of shares of an ETF needs to be reduced, the process is reversed: APs buy ETF shares from the market and return them to the issuer in exchange for underlying assets proportionate to those shares. That helps keep the trading price of ETFs close to the net asset value of their underlying assets and minimizes cost inefficiencies.

What are the different types of ETFs?

Investment style

You can differentiate ETFs based on how they’re managed – actively or passively – to meet specific investment goals.

• Active ETFs: Managed by a portfolio manager who proactively selects investments to try to outperform a benchmark index. This style can adapt to market fluctuations but tends to have higher fees.
• Passive ETFs: Designed to replicate the performance of a specified index, such as the S&P 500, without frequent trading. This approach is favored for its lower costs and transparency.

Assets

You can differentiate between ETFs based on the type of assets that it invests in. For example:

• Stock ETFs: Tracks a group of equities from specific sectors, countries, or that are exposed to a specific theme**.**
• Bond ETFs: Invest in various types of bonds, offering regular income and lower risk compared to stocks.
• Commodity ETFs: Either invests directly in physical commodities like gold or oil, or in commodity-linked derivative contracts.
• Currency ETFs: Track the performance of single or a basket of currencies, offering exposure to foreign exchange markets.
• Crypto ETFs: Provide exposure to cryptocurrency markets without the need for direct investment in digital assets.
• Real Estate ETFs: Invests in real estate investment trusts or real estate stocks, providing exposure to real estate markets without requiring direct property ownership.
• Derivatives ETFs: Uses futures, forwards, and/or options to achieve investment goals like hedging risks or enhancing returns.

Investment strategy

You can differentiate between ETFs based on the investment strategy it is pursuing. For example:

• Inverse ETFs: Aims to profit by shorting stocks. An inverse ETF increases in value as the stocks it targets decrease in value.
• Leveraged ETFs: Aim to deliver multiples of the daily performance of the underlying assets, using financial derivatives and debt to amplify returns or losses.
• Regional ETFs: Focus on specific geographic regions, allowing investors to target their exposure to emerging markets or developed countries, say.
• Dividend ETFs: Target stocks that pay high dividends, providing investors with steady income in addition to potential capital gains.
• ESG ETFs: Focus on companies with strong environmental, social, and governance practices or scores, aligning investment strategies with ethical principles.
• Thematic ETFs: Invest in stocks that align with a particular theme or trend, such as technology advancements, healthcare innovations, or green energy.
• Volatility ETFs: Designed to trade on the volatility of the market rather than the price of stocks themselves, often used as a hedge against market downturns.

Issuers mix and match styles, assets, and strategies to create an ever-growing range of ETFs to potentially invest in. For instance, an issuer might offer a passive bond ETF with a focus on ESG principles – as well as an actively managed leveraged commodity ETF. Each combination offers a different package of risks and potential upsides, that may be relevant and attractive to different types of investors.

What are the advantages of ETFs?

1. Cost-effectiveness: ETFs typically have lower expense ratios compared to actively managed, non-exchange-traded funds. That lower cost is more pronounced for passive ETFs, whose management requires less frequent trading and a lower administrative burden.

2. Tax efficiency: ETFs are generally more tax-efficient than mutual funds, thanks to their unique structure. This allows them to minimize capital gains distributions by using in-kind transfers for redemptions and creations of fund shares.

3. Liquidity: Like individual stocks, ETFs are traded on stock exchanges, allowing investors to buy and sell shares throughout the trading day at market-determined prices. This makes it easy for investors to enter or exit positions.

4. Accessibility and flexibility: ETFs can be bought and sold like stocks on an exchange, providing investors with the ability to place a variety of order types (e.g., market, limit, and stop orders), use options, or even sell short.

5. Portfolio diversification: By investing in an ETF, investors can gain exposure to a wide array of assets within a single transaction. ETFs can include hundreds or even thousands of stocks across various industries, bonds of different types, or a mixture of asset classes, providing diversification benefits.

What are the risks and disadvantages of ETFs?

1. Market risk: Like any investment, ETFs are subject to market risk. This means that the value of the ETF can fall (as well as rise) in line with the assets it tracks.

2. Liquidity issues: Although the biggest ETFs are generally highly liquid, some specialized ETFs – like those tracking less popular assets – might have lower trading volumes, which could lead to higher trading costs and price volatility.

3. Tracking error: ETFs might not exactly replicate the performance of the assets it aims to track due to timing differences, changes to the underlying assets, or costs associated with running the fund.

4. Additional costs: While generally cost-effective, some ETFs – especially if they’re actively managed, involve complex strategies, or invest in illiquid assets – may have higher fees that eat into your investment returns.

5. Over-diversification: While diversification is usually a benefit, overly broad exposure through certain ETFs can dilute potential gains from strong performers, as their outperformance is offset by the fund’s underperformers.

6. Counterparty risk: This applies particularly to ETFs that use derivatives to achieve their investment goals. If the counterparty to a derivative contract fails to fulfill its obligations, the ETF can suffer losses.

What is the difference between an ETF and a mutual fund?

ETFs and mutual funds share some similarities but differ significantly in their structure and trading mechanics. While both pool investor money to purchase a portfolio of assets, there are some key differences.

How do you buy ETFs?

1. Open a brokerage account: Choose a reputable broker that provides access to the stock market. Complete the registration process, which will include providing financial information and setting up a way to fund your account. Once your account is active and funded, you can begin purchasing ETFs much like individual stocks.

2. Research ETFs: Use ETF screening tools to filter and compare ETFs that meet your investment criteria. Consider factors such as the ETF’s focus (i.e. style, asset, strategy), performance history, expense ratio, and valuation.

3. Place an order: Once you've selected an ETF, decide how much you want to buy and select an order type (e.g., market order, limit order). Confirm the details and execute the trade.

4. Monitor your investment: Keep track of your ETF’s performance and the overall market conditions. Most platforms offer tools to review your investment portfolio and make adjustments as needed.

FAQs about ETFs

Is an ETF better than a fund?

Whether an ETF is better than a mutual fund depends on individual investment goals and preferences. ETFs typically offer lower expense ratios and greater tax efficiency compared to mutual funds. They also provide the flexibility to trade throughout the trading day like stocks. However, some mutual funds may offer advantages in automatic dividend reinvestment and easier management for regular contributions.

Are ETFs riskier than stocks?

ETFs, which can hold a diversified portfolio of stocks, bonds, or other assets, generally offer lower risk compared to individual stocks due to their inherent diversification. However, the risk level of an ETF depends on its underlying assets. For instance, an ETF that tracks a volatile sector or uses leverage may be riskier than a single stable stock.

Do ETFs pay dividends?

Yes, ETFs can pay dividends if their underlying assets generate dividend income. The dividends are collected by the ETF and then distributed to its shareholders. The frequency of dividend payouts can vary depending on the specific ETF, with some paying quarterly, others semi-annually, or annually.