What’s an Exchange-Traded Fund? (ETF) — The Pros and Cons
In the financial world, there's no shortage of acronyms and jargon. However, among the array, ETFs, or Exchange-Traded Funds, stand out as an essential concept for both novice and seasoned investors. Designed to offer the diversification benefits of mutual funds while mimicking the simplicity of trading a single stock, ETFs have seen exponential growth in their popularity and assets under management over the past couple of decades.
What is an ETF?
An ETF is an investment fund that holds a collection of assets, such as stocks, bonds, or commodities, and is traded on stock exchanges. Think of it as a basket of different assets that you can buy or sell through a brokerage account. It offers the ability to invest in an entire sector, industry, or country with the purchase of just one security.
How do ETFs Work?
Creation and Redemption Process: ETF shares are created when an authorized participant, usually a large financial institution, gives the required portfolio of underlying assets (like stocks or bonds) to the ETF in exchange for shares of the ETF. Conversely, ETF shares are redeemed when the authorized participant gives back the ETF shares and receives the underlying assets in return. This unique process keeps an ETF’s trading price in line with its intrinsic value.
Trading: Unlike mutual funds, which are priced at the end of the trading day, ETFs are priced and traded throughout the day on stock exchanges, just like individual stocks. This provides flexibility, as investors can place a variety of order types, such as limit orders or stop-loss orders.
Diversification: Each ETF is designed to track the performance of a specific index, sector, commodity, or asset class. Thus, by investing in an ETF, you get exposure to all the components of the index it tracks. For instance, if you invest in an ETF that tracks the S&P 500, you're essentially investing in the 500 largest U.S. publicly traded companies.
Advantages of ETFs
Liquidity: Since ETFs are traded on major stock exchanges, they offer high liquidity, allowing investors to quickly buy or sell shares.
Cost-Efficiency: ETFs generally have lower expense ratios compared to traditional mutual funds. Plus, because they track an index, there’s typically less turnover, potentially leading to fewer capital gains taxes.
Transparency: ETFs disclose their holdings daily, giving investors a clear view of what assets are inside the fund.
Flexibility: They can be bought or sold at any time during the trading day at market price, and investors can employ traditional stock trading techniques, such as short selling or buying on margin.
Access to many investment strategies: ETFs can be simple or complex, allowing you to invest in complex strategies that would be hard to replicate on your own.
Potential Drawbacks
Tracking Errors: There can be discrepancies between the performance of the ETF and the underlying index it's meant to mimic, though this is generally minimal.
Dividend Payment Delays: Unlike individual stocks, where dividends are paid soon after declaration, ETFs may sometimes hold onto dividends until the end of the month or quarter.
Some ETFs Can be Dangerous: Generally, broad-index ETFs are safe, but there are other complex ETFs out there, such as leveraged ETFs, that can lose investors lots of money if they aren’t careful with them. Check out our article on leveraged ETFs here: Leveraged ETFs: What They Are and Why They Can Be Dangerous
Expense ratios: Buying an individual stock doesn’t carry an expense ratio with it. However, when you buy an ETF, you have to pay fees, known as an expense ratio. However, these are usually cheap. For example, if you buy the VOO ETF, which tracks the S&P 500, you will only pay an expense ratio of 0.03% per year, meaning that if you invest $1,000 in the ETF, you’d pay just $3 in fees after a year.
Types of ETFs
Equity ETFs: These invest in shares of stock and offer a way for investors to buy a broad portfolio of assets. Example: the SPY ETF, which tracks the S&P 500 Index.
Bond ETFs: Target government, corporate, municipal, or international bonds. Example: the TLT ETF, which invests in 20+ Year U.S. Treasury bonds.
Sector and Industry ETFs: Focus on specific sectors like technology, healthcare, or finance. Example: The XLK ETF, which invests in technology stocks.
Commodity ETFs: Invest in commodities like gold, oil, or agricultural products. Example: The GLD ETF, which tracks gold.
International ETFs: Offer exposure to markets outside of the investor’s home country. Example: the Schwab International Equity ETF (Ticker: SCHF) is a popular international ETF.
Thematic ETFs: Focus on specific themes or strategies, such as environmental, social, and governance (ESG) criteria. Example: iShares ESG Aware MSCI USA ETF (Ticker: ESGU) is a popular ESG ETF.
Leveraged ETFs: These are leveraged and generally aim to deliver two or three times the daily return of a given underlying index. For example, the SPXL ETF seeks to replicate the returns of the S&P 500 by a factor of 3x. Example: if the S&P 500 returns 1% on a given trading day, SPXL should return close to 3%.
In Conclusion
The rise of ETFs underscores a shift in the investing world towards instruments that are transparent, flexible, and cost-effective. For those new to the investment scene, ETFs provide a relatively low-barrier entry to diversified investing, and for the seasoned pros, they're tools to efficiently fine-tune portfolios. Like all investments, it's essential to do your due diligence and assess whether ETFs align with your financial goals and risk tolerance. But given their multifaceted benefits, they're undoubtedly worth considering for any investment toolkit.
