ETFs, or exchange-traded funds, are an excellent way of investing in the securities markets. ETFs include a basket of securities to trade on the stock exchange, like mutual funds.
They are simple to understand and can generate significant returns at a minimal expense.
What is an ETF?
Exchange-traded funds, or ETFs, are pooled investment securities traded on a stock exchange. An investor can buy a portion or shares of an ETF, and the fund fulfills the ETF's objective.
Like stocks, investors trade ETFs on major stock exchanges, like NASDAQ and NYSE. In addition, ETFs can contain all types of investments, like stocks, bonds, and commodities. Moreover, they can offer domestic or international shares.
Types of ETFs
Here are some of the types of ETFs currently available on the market.
- Active and Passive ETFs. Actively managed ETFs typically have portfolio managers who decide which shares to include in the investment portfolio. Active ETFs will focus on outperforming the stock index and tends to be an expensive option. On the other hand, passive ETFs will track stock indexes and will tend to match the index's performance.
- Stock ETF. Stock ETFs include shares focusing on a particular industry or sector, such as the auto industry. This ETF offers a diversified portfolio from a specific industry or sector that is high performing, new to the market, or with growth potential.
- Bond ETF. Bond ETFs include a collection of government, corporate, state, and local bonds that provides a steady income to investors. Bond ETFs do not have a maturity date and trade at a premium or discounted price.
- Commodity ETF. Commodity ETFs invest in commodities like gold and crude oil. They offer a diversified investment portfolio and can provide cushioning during a slump in the market. In addition, holding shares in a commodity ETF is cheaper since they do not require insurance or storage costs for the physical goods.
- Currency ETF. Currency ETFs are investments that track the prices of both domestic and international currencies. They offer a diversified portfolio and can help against a stock market slump.
- Sector or Industry ETF. Sector or industry ETFs offer a collection of securities from a particular sector or industry. For instance, a technology ETF will include shares from technology companies. They also protect against any downfalls in the market since they do not require direct ownership of securities.
- Leveraged ETF. Leveraged ETFs offer a return that equals multiples of the return on the invested securities. For instance, in a 2x leveraged S&P 500 ETF, investors will get a 2% increase in share prices when the ETF index rises by 1%.
- Inversed ETF. Inverse ETFs allow investors to gain when the market falls.
Understanding Risks and Returns
An ETF is a marketable security that you can buy and sell daily. Whenever an investor purchases shares in an ETF, they'll have fewer risks as the investment spreads over a collection of stocks.
To improve returns and minimize risks, investors must consider the following while investing in ETFs:
- Performance. While past performances do not indicate future results, it's best to consider this when comparing ETFs.
- Expense. Consider ETFs with a lower expense ratio to lower administrative costs.
- Volume. Trading ETFs at a higher volume would help compare the popularity of different funds.
- Holdings. Having a portfolio in other ETFs allows the investor to compare their diverse holdings.
Benefits and Limitations
Investing in ETFs can have the following benefits and limitations:
- Diversification: ETFs help diversify your portfolio by investing in a cluster of shares in one fund. Diversification can lower your overall investing risk.
- Tax Efficiency: ETFs minimize capital gains, making them a tax-efficient option.
- Low Cost: With ETFs, you can invest in a diversified portfolio at a lower price.
- Passively Managed: You can have passively managed where you can track a preselected index of stocks and bonds.
- No Trading Commissions: Online traders do not charge commissions on ETFs, keeping expenses low.
- Focused Trading Options: With ETFs, you can focus on investing in a particular industry or sector, like energy or technology, if you think the share prices of that sector are poised to rise.
- Can Be Overvalued: As ETFs trade throughout the day, they can be overvalued compared to their holdings.
- Not Targeted as Expected: While investors use ETFs to invest in a particular sector, they can have a predominant holding in one industry with small holdings in other smaller sectors.
- May Have Higher Fees Than Stocks: An ETF that follows a low-volume index might increase the bid or asking spread.
- Lower Dividends: The returns on ETFs may be lower than individual stocks.
ETFs allow you to diversify your investments without having to purchase individual stocks. However, they may come with higher costs and potentially lower dividends than high-yielding stocks.