Exchange-Traded Fund (ETF) is a type of investment created to get benefits with an advancement in it. They have gained so much popularity among individual and institutional investors. In short, they incorporate the mutual fund benefit and the advantages of stock trading. So, it is an inexpensive way to produce an essential diversified portfolio.
Thus, it is going to be a general overview of ETFs, describing how ETFs work, comparing the pros and cons of ETFs, and step-by-step guidance on how investors can invest in ETFs.
What is an Exchange-Traded Fund (ETF)?
An Exchange-Traded Fund (ETF) is an investment fund offered to investors that pools money from multiple investors to buy a collection of assets, such as stocks, bonds, commodities, or other securities.
Unlike mutual funds, where one can acquire or dispose of holdings only at the end of a trading day, an ETF is traded on stock exchanges during the day, exactly like stocks in an individual company. That would then mean that their prices are changing in real-time as they get bought and sold on the market. Most ETFs are indexed funds that track an index, such as the S&P 500, NASDAQ, or a sector-based index. Then there are actively managed ETFs in which professional managers make choices about the assets that will be purchased with specific strategies. ETFs allow investors to gain exposure to virtually any type of asset or sector without having to purchase each underlying security.
How do ETFs work?
ETFs base their work upon holding an underlying basket of assets. And the shares of the ETF itself serve as a proportionate interest in those assets. That is to say, in their simplified version, this is how they work:
1. Asset Pooling: The ETC provider will go out and purchase either equities or bonds as delineated by the objective of that specific fund. For example, an S&P 500 ETC. This will own equities of the companies in the S&P 500 Index.
2. Issuance: The ETC issuer issues shares, that is, fractional ownership of those pooled assets. Investors will purchase these shares on an exchange.
3. Spot markets. The shares are traded on the stock exchanges. The supply and demand determine the trading price of the shares within the trading day. As such, this opens avenues for investors to acquire and sell the share units of the ETF anytime the market is operational.
4. Performance Monitoring: The passive ETF tracks the performance of the underlying index or assets. An actively managed ETF may include the managers buying and selling assets for some specific investment objectives.
Kinds of ETFs
There are a numerous kind of ETFs and they come in many different designs to offer something for investment strategies and goals. A few examples include:
• Stock ETFs: Follow a particular stock index, sector, or geographical region.
• Bond ETFs: These are basically fixed-income-based securities like government, corporate, or municipal bonds.
• Commodity ETFs: These are composed of physical commodities like gold, oil, or agricultural products.
• Sector and Industry ETFs: These will track a specific sector, for instance, technology, health, or energy.
• International ETFs: International ETFs, in general, will offer exposure to markets outside of an investor’s home country, whether emerging or developed.
• Thematic ETFs: They provide thematic exposure, based on themes such as renewable energy, technology innovation, or artificial intelligence, among others.
• Inverse and Leveraged ETFs: These types of ETFs are leveraged to magnify the return, using a derivative that multiplies the performance (or the inverse) of the index, which it tracks.
Why invest in ETFs
ETFs have many benefits; it is suitable for new and experienced investors:
• Diversification: ETFs provide a basket of securities, which reduces risk compared to placing investment directly in stocks.
• Liquidity: Since ETFs are traded on the stock exchange, it is highly liquid, and even the investor may buy or sell through market hours at real-time prices.
•Cost-Effectiveness: ETFs are less costly as they adopt a passive approach. Many brokerages allow trading on their platforms free of charge.
•Transparency: Most ETFs describe their holdings daily; thus, an investor would know what he owns.
•Flexibility: ETFs can be invested in for short-term or long-term. They also allow investment in specific sectors, asset classes, or regions.
Risks associated with Investing in ETFs
ETFs have their risks too though the list is long but has been summarized below:
•Trading Costs: Frequent trading ETF attracts costs such as transaction commission and spread cost. This may be a burden for the small investor.
• Market Risk: ETFs share the same market risk of the underlying assets; hence, in case the market takes a downturn, then investors stand to lose.
•Tracking Error: Some tracking ETFs never map exactly to the performance of the underlying index therefore, creating a “tracking error”.
•Limited Personalization: ETFs track a predetermined basket of assets, and the investor has no say in what goes into the fund (except for actively managed ETFs, which are more expensive).
How to Invest in ETFs?
It’s very simple to invest in an ETF. Here are the steps to guide you through the process:
- Step 1: Define Your Investment Goals Define your investment objectives. You should also know your risk tolerance and time horizon – these are critical components to determining which ETFs are a good fit for you.
- Step 2: Open an Online Brokerage Account You will need to have an online brokerage account to invest in ETFs. Fortunately, there are hundreds of online brokerages that support trading in ETFs. While you can get commissions as low as $1 per trade up to a flat price of zero for executing your trades, you have various choices to choose a broker that is competitive in terms of pricing, easy to use, and comes equipped with good research tools.
- Step 3: ETFs Researching Run your goals and brokerage account through to begin researching the ETF that best fits your strategy.Some things to look at may include:
Expense Ratio: The lower, the better for long term investments.
Historical Performance: Look at how it’s performed in the past but don’t use it as a promise for future investment.
Underlying Index: What’s the ETF tracking- is it an index, sector or commodity?
Liquidity: It is easier to buy and sell highly liquid ETFs since the spreads between asked and bid prices are narrower.
Step 4: Portfolio of holdings of an ETF: Pass through the portfolios of the holdings of an ETF to know whether you align well with your investment. Here is an easy example of a technology ETF holding stocks by huge firms like Apple, Microsoft, or Google.
Step 5: This is followed by doing your order.Once you have made up your mind as to which ETF you want to invest in, you can then buy that through your account at a brokerage. In this regard, trading of ETFs is very much akin to trading of stocks. Hence, you can place market as well as limit orders. Market orders buy the ETF at prevailing prices whereas a limit order lets you set the price at which you are ready to pay.
Step 6: Tracking Your Investment: In most cases, after investing in the ETF, it is prudent that you track how the fund performs, and at times you might need to revisit your portfolio and analyze whether it still meets your pre-set set goals. Sometimes, you might have to rebalance your portfolio or reposition your holdings based on a particular market situation or your personal goals.
Conclusion
It is a simple and relatively cheaper diversified investment in different assets, and thus allows all types of investors to invest suitably. It provides the option of mutual funds combined with ease of trading stocks as it provides broad exposure to markets. You can then make use of knowledge of your financial objectives, research existing ETFs, and make use of a reliable brokerage platform to make ETFs an important part of your investment strategy.