Currently, an ETF may be an excellent investment instrument for both small and large investors. These popular funds, which are comparable to mutual funds, have been a popular alternative among investors seeking to diversify their portfolios without the time required to manage and allocate their investments. However, it still has some disadvantages that investors may not know. Therefore, this article is conducted to clarify all of its details to make investors more clearly understand.
Table of contents
What Exactly Is ETF?
To begin, ETF stands for exchange-traded fund. It is a kind of pooled investment product that functions similarly to a mutual fund. It often follows a specific index, sector, commodity, or other assets. However, unlike mutual funds, ETFs may be bought and sold on a stock market in the same way that normal stocks can. Moreover, it can be designed to track anything from a single commodity’s price to a huge and diversified group of commodities. Additionally, itcan even be designed to follow certain investing strategies. Importantly, the SPDR S&P 500 ETF (SPY) was the first ETF and is still an actively traded today.
Besides, an ETF is exchanged on a stock exchange, much like stocks. Thus, the value of its shares fluctuates during the trading day as they are purchased and sold on the market. In contrast, mutual funds are not traded on an exchange and trade just once each day after the markets shut. Furthermore, as compared to mutual funds, ETFs are less expensive and more liquid.
Working Principles of ETF
Throughout the day, when the stock markets are open, an ETF is bought and traded much like a common stock. It has a ticker symbol, and real-time price data is easily available during the trading day.
However, it is different from common stocks in the number of shares. The number of shares outstanding of an ETF, unlike a corporate stock, can fluctuate daily. This is because of the continual production of new shares and redemption of existing shares. Moreover, the capacity of it to continuously issue and redeem shares maintains the market price of it in line with the underlying assets.
While the ETF is intended for ordinary investors, institutional investors play an important role in ensuring its liquidity and tracking integrity by purchasing and selling creation units. Importantly, these purchasing and selling are huge blocks of its shares that may be swapped for baskets of the underlying assets. Therefore, when the price of an ETF deviates from the underlying asset value, institutions use the arbitrage mechanism provided by creation units to bring its price back into line.
Type of ETFs
Generally, investors can choose from a variety of ETFs that can be utilized for income generation, speculation, and price gains. Additionally, investors use it hedge or partially offset risk in their portfolios. Here is a quick summary of some of the them that are currently available on the market.
1. Leveraged ETF
A leveraged ETF intends to outperform the underlying investments by a ratio of two or three. For example, if the S&P 500 grows 1%, a 2 leveraged S&P 500 it will rise 2%. On the other hand, if the index falls by 1 percent, it would lose 2 percent. Importantly, these products leverage their profits by utilizing derivatives such as options or futures contracts. In addition, it seeks an inverted compounded return.
2. Commodity ETF
Commodity ETF, as the name indicates, is the investing in commodities such as crude oil or gold. Importantly, it provides various advantages. The first is that they diversify a portfolio, making it easier to hedge against downturns. Thus, it can protect during a stock market downturn. Second, owning shares it is less expensive than owning the commodity itself. This is because the former does not require insurance or storage.
3. Bond ETF
Bond ETF is intended to give investors with consistent income. Significantly, their income distribution is influenced by the performance of the underlying bonds. Nevertheless, unlike their underlying products, it does not have a maturity date. They often trade at a premium or discount to the underlying bond price.
4. Industry/ Sector ETF
Industry ETF is a fund that invests in a certain industry or area. The objective behind it is to acquire exposure to the upside of a certain industry by following the performance of firms in that field. An example is the IT industry, which has seen a recent flood of cash. Simultaneously, since it does not entail direct ownership of shares, the downside of erratic stock performance is also limited. Moreover, during economic cycles, it is also utilized to rotate in and out of sectors.
5. Passive and Active ETF
Normally, an ETF is classified as either passive or actively managed. However, passive ETFs seek to imitate the performance of a wider index such as the S& P 500 or a more specialized focused sector. Importantly, gold mining stocks are an example of the latter category.
6. Currency ETF
Currency ETF is pooled investment that follows the value of currency pairings. It includes both domestic and foreign currencies. Essentially, it fulfills several functions. They may be used to speculate on currency values depending on a country’s political and economic trends. Additionally, importers and exporters use it to diversify their portfolios or as a hedge against volatility in Forex markets. Moreover, some are also employed to protect against the possibility of inflation.
7. Inverse ETF
Generally, shorting stocks allows an inverse ETF to profit from stock falls. Moreover, shorting a stock is selling it with the expectation of repurchasing it at a cheaper price. To short a stock, it employs derivatives. Essentially, it is wager on the market falling. When the market falls, it gains in proportion. Many of them are exchange-traded notes (ETNs) rather than real ETFs. Thus, investors should be aware. An ETN is a bond that trades like a stock and is backed by a bank or other issuer.
Stock ETF
Stock ETF is a collection of equities that track a certain industry or sector. Generally, it may follow automotive or international equities. Importantly, the goal is to give diverse exposure to a particular industry that includes both excellent performers and new entrants with development potential. However, unlike stock mutual funds, it features cheaper costs and do not require real ownership of stocks.
Example of Popular ETFs
The following are some examples of popular ETFs on the market today. Some of them monitor a stock index, whereas others target specific industries.
- The SPDR S&P 500 (SPY)
The “Spider” ETF is the oldest and most well-known ETF that tracks the S& P 500 Index.
- The SPDR Dow Jones Industrial Average (DIA)
The “Diamond” ETF covers the Dow Jones Industrial Average’s 30 stocks.
- The iShares Russell 2000 (IWM)
This ETF monitors the Russell 2000 small-cap index.
- The Invesco QQQ (QQQ)
The “Cube” ETF represents the Nasdaq 100 Index, which is composed primarily of technology equities.
ETF Advantages And Disadvantages
Since it would be costly for an investor to acquire all of the equities contained in an ETF portfolio individually, it offers reduced average costs. Therefore, investors just need to perform one transaction to purchase and one transaction to sell. It results in lower broker commissions as investors only make a few trades. Additionally, brokers usually charge a fee for each deal. However, some brokers even provide no-commission trading on select low-cost ETFs, significantly lowering investor costs.
Besides, the price of an ETF is the cost of operating and managing the fund. Since they follow an index, an ETF often has low expenses. For instance, if it tracks the S& P 500 Index, it may comprise all 500 S& P equities. Thus, this makes it a passively managed fund that is less time-consuming. Nonetheless, not all of them track an index passively and hence may have a higher cost ratio.
Advantages
- Risk can be reduced through diversity
- Can access a wide range of equities from various industries
- Has fewer broker commissions and low expense ratios
- Some ETFs specialize in certain sectors
Disadvantages
- Diversification is limited by single-industry ETFs
- Transactions are hampered by a lack of liquidity
- Fees for actively managed ETFs are higher
Conclusion
In short, an ETF is a mutual fund that tracks the performance of a certain index such as the S& P 500. Importantly, it can be traded on a stock exchange at any time during market hours. Moreover, it is a simple and strong investing alternative to help you accomplish your objectives, whether you are an individual wanting to invest or a seasoned financial expert. However, you should deeply understand it before investing because every investment is full of risks.
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Read more: Investing
Source: Investopedia