The Complete Beginner’s Guide to ETFs
What is an ETF?
In the stock exchange, there’s usually a package of securities that you can trade through a brokerage firm. This package is referred to as an ETF (Exchange-Traded Fund). ETFs are available in almost all groups of assets; from the more traditional investments to other assets such as currencies or commodities.
Over the past few years, ETFs have emerged to be one of the best and most viable products created for individual investors. They bring to the table a wide range of benefits, and if they are used wisely, they are a great investment vehicle that investors can use to achieve their financial goals.
You will find ETFs being offered on almost every imaginable group of assets, ranging from the more traditional investments to the earlier mentioned alternative assets. Moreover, the structure that ETFs operate on will allow investors to gain leverage and also to make short markets. The structure also allows investors to get away from the taxes associated with short-term capital gains.
In 1993, ETFs began in earnest, just after two failed starts in the previous years. They began with what later became the highest volume of ETF in history; “Spiders,” whose only identification was its ticker symbol, SPY. This number rose continuously over the years, and it’s now believed to be at over $1 trillion worth of ETF investments. There are also approximately 1,000 products that have been traded on the U.S stock exchange.
Types of ETFs to buy
Here’s some of the best ETF to invest:
- Market ETFs: Designed to track particular indices. For instance, the NASDAQ or the S&P 500.
- Bond ETFs: Designed to give maximum exposure to all available bond types. These include US Treasury, high-yield, municipal and international among others.
- Industry and Sector ETFs: Just as their name suggests, sector ETFs were designed to focus on a particular industry. For example, high energy, pharmaceuticals or oil.
- Commodity ETFs: Designed to keep track of the price of a particular commodity. It could be oil, gold or corn.
- Style ETFs: Designed to keep track of the emerging investment styles or the focus of market capitalization like small-cap growth or large-cap value.
- Foreign-Market ETFs: Created to track markets outside the US, such as the Hang Seng index of Hong Kong or Nikkei Index of Japan.
- Inverse ETFs: Built to operate in the underlying index or market experiencing a decline and also make a profit from them.
- Actively-Managed ETFs: Unlike the other ETFs whose intention is to track indices, actively-managed ETFs are used to outrun indices.
- Exchange-Traded Notes: These are debt securities that enjoy the backing of the creditworthiness of the bank issuing them. They were created to give access to illiquid markets. Moreover, they have the unique ability to generate literally zero gains taxes on short-term capital.
- Alternative Investment ETFs: These allow investors to gain exposure to or trade volatility on a particular investment strategy, like covered call writing or currency carry.
How Do ETFs Work? How to invest in ETF?
When the stock markets are open, an ETF (Exchange-Traded Fund) is bought and also sold just like any other company stock. Also similar to company stock, the ETF has a ticker symbol. The intraday data can also be obtained easily throughout the trading day.
Due to the redemption of already existing shares and the creation of new ones, there’s a real possibility of a daily change in the number of outstanding ETF shares. The company stocks don’t behave in the same way. The unique ability of ETF to consistently redeem shares and issue new ones keeps their market price aligned with their equal counterparts in the securities.
Although the ETFs originally targeted individual investors, institutional investors have played a major role in the maintenance of liquidity and tracking of ETF integrity. They do this by purchasing and selling creation units. Creation units are huge blocks of ETF shares which can be exchanged for other similarly huge packages of underlying securities. The price of ETFs can be brought back to the line with the value of the underlying assets if and when their price deviates from the value of the underlying assets. This is done through the maximum utilization of the arbitrage mechanism that creation units boast of.
ETFs and Traders
Seeing that the package of underlying assets and ETFs are both tradeable throughout the day, traders always aim to keep the price of ETFs close to their fair value. They achieve this by taking full advantage of the momentary arbitrage opportunities. A trader can lock in the differential by buying ETF shares and selling the underlying portfolio. This can only happen if the trader buys the ETF shares at a lower price than the underlying securities.
Some ETFs may use derivative products to create leverage or inverse ETFs. They do this by either taking advantage of leverage or gearing. Inverse ETFs operate by tracking the inverse return of the assets underlying the ETFs. For instance, for every 1% drop in the price of gold, the inverse ETF of the same metal gains 1%. Leveraged ETFs, on the other hand, aim to gain the returns of the underlying assets multiple times. For a 1% gain in the price of gold, there would be a 2% gain for a 2x gold ETF.
How to Buy an ETF?
Just like normal shares, ETFs are usually traded on multiple exchanges. You can buy and sell ETFs via any experienced stockbroker. The prices associated with this trade are similar to those involved in shares.
Draper, who works at Credit Suisse, says that stamp duty on ETFs doesn’t exist. He goes on to say that some ETFs can be held in an individual savings account that’s also tax-friendly. For the tax year that ended on 5th April 2011, the Isa allowance, calculated annually, was 10,200 sterling pounds. Some other ETFs may also be held in an SSIP. This is a self-invested personal pension.
Advantages of ETFs
Why invest in ETFs? Why are ETFs good? What attracts individual investors to ETFs are:
- You can buy and sell ETFs throughout the day: Mutual funds, on the other hand, settle at the end of the day when the market closes.
- Lower fees: Sales loads are non-existent. However, brokerage commissions apply when trading ETFs
- Higher tax efficiency: Compared to when investors pay taxes in capital gains, they enjoy better control when trading in ETFs.
- Trading transactions: Since ETFs are bought and sold like stocks, investors can choose to place a wide range of orders. Mutual funds don’t support this function. The types of orders include stop-loss orders, limit orders and buy on margin.
Disadvantages of ETFs
Why are ETFs bad? While the advantages of ETFs may be superior, they also have some disadvantages which include:
- Trading costs: Choosing a direct investment with a no-loan company fund may prove to be a lower-cost alternative when compared to frequently investing in small amounts.
- Illiquidity: Due to the wide bid/ask to spread of the thinly traded ETFs, you will have to sell only at the low price of the spread and buy at the high price of the spread.
- Tracking error: Some technical issues can lead to discrepancies even though ETFs track their underlying index quite well.
- Settlement dates: It takes two days for your funds as a seller to be credited to your account. This means that you will not be able to reinvest for two days after making the sale.
Once you have a clear understanding of your investment goals, you can fully use ETFs to give you exposure to any imaginable market or industry sector in the world. You can then invest your money as usual by using bond ETFs and stock index while adjusting the allocation for each depending on the changes in your goals and you risk tolerance. You can also include other things such as commodities, gold or the newest stock markets. Just like a hedge fund, you can choose to quickly make your way into and out of the markets with the hope of catching swings for the short term. The point in this is that ETFs afford you the flexibility of choosing what kind of investor you want to be.
Are ETFs Tax Efficient? Not Always
Since ETFs allow in-kind exchanges to happen for authorized participants (AP), they are considered to be tax efficient. Translated into simpler terms, this means that an authorized participant can choose to receive the actual shares in the company that he has invested in, in exchange for the ETF shares that he already owns. After acquiring these shares, he can now sell them in the market.
This exchange is designed in such a way that most capital gains are eliminated since the actual ETF doesn’t necessarily have to sell shares. This means that unlike mutual funds, a capital gain distribution is off the table.
However, capital gains can be incurred if there happens to be a subtraction or addition in the underlying index, causing the ETF to change the index.
Besides the above, there are some more circumstances which may lead to capital gains. These include leveraged ETFs and managed ETFs. International funds may also lead to this since in-kind exchanges are not supported by all countries. If you choose to invest in these ETFs, you need to have some extra cash to pay for the taxes or ensure that the account holding them is non-taxable.
Watch Out for Fees
The main advantage of ETFs is the low fees that they boast of. They charge just a mere fraction of what mutual funds ask for. Another advantage is that all your money can be invested because of the lack of deferred loads or front loads.
However, ETF fees have a drawback in that you are required to pay a commission each time you purchase ETF shares. This price can add up if you average your dollar cost each month. If, also, you choose to reinvest your dividends, you will still need to pay a commission for reinvestment. In mutual funds, on the other hand, no additional fees are required for reinvesting dividends.
It’s possible to get around the extra fees by choosing a brokerage firm that waives the reinvestment fees from dividends, or that offers some of these commissions for free.
Going the Extra Mile
Since ETFs and stocks are traded in a similar way, you can use some advanced strategies such as short selling, stop-loss orders, and options.
If you have little knowledge of these strategies, it would be wise not to take the risk since you can lose your investment. This option is not available if you are investing in a mutual fund. Avoid taking the risk.
If you are well vast in these investment strategies, you can easily get your investment back. In general, you will need to ensure that the new trading capabilities are compatible with your skill set. You don’t want them to affect your investment.
ETFs make it incredibly easy to specify your area of investment; a country, sector with a single strategy. This is great because you can get to learn and understand the market.
There are some disadvantages, however. Most of the niche funds are too small, and this may lead to liquidity issues if the need to sell arises.
What Does the Future Hold for ETFs?
Since its creation two decades ago, ETFs have continuously evolved, and they continue to do so. It’s needless to say that the future is definitely bright for this vehicle of choice for many investors. The decision to invest in an ETF should be made after carefully investigating your chosen company and considering all factors.
How to Use ETFs in Your Portfolio?
Investing in ETF doesn’t necessarily guarantee a positive return from your investments. A strategic investment plan can, however, guarantee that you get the return you’re hoping for.
Here are some of the steps that you need to take:
- Index investing with EFTs
- Active management of a longer-term portfolio
- Trading actively with EFTs
- Wrap investing with EFTs
ETFs have grown in popularity very fast which has led to some experts predicting that they might soon overtake mutual funds. They are flexible, cost-efficient and convenient. Chances are high that they might find their way into your portfolio very soon, that is if they haven’t already.