By Holger Reinel | Updated on April 20, 2020
Have you ever wondered what an ETF (Exchange-Traded Fund) is and how it works?
An Exchange-traded fund (ETF) is a basket of securities including stocks, commodities, and bonds that you can purchase for one price; it is designed to replicate the movements of a specific index such as the S&P 500 or the Nasdaq 100.
Thus, ETFs are index funds that you can trade in the stock market.
ETFs are an attractive way of investing because they provide you easy access to a diversified portfolio of securities while keeping management fees low. Their value equals the value of all the underlying investments (stocks, bonds, commodities) held by that ETF.
The main reason why ETFs have won the battle for investors’ money is because they offer a low-cost access to stock markets, while allowing investors, big and small, the ability to build a well-balanced portfolio.
Like index funds, ETFs are passively managed, diversified and low cost; however, ETFs can be traded intraday similar to how stocks are traded.
When an investor buys an ETF they are really buying a position into all the investments held in that specific ETF. For example, if you buy an ETF that has shares from Tesla, Facebook, and Apple, you’re buying exposure into all those three companies with one single trade.
Thus, the ability to build a well-diversified portfolio in a single trade provides investors an easy and inexpensive way to invest.
ETFs is also a good vehicle for ESG (environmental, social, and governance) investing; ESG investments align money with opportunities that are consistent with core values that specific investors believe in.
All that interest leads people to wonder, what’s so good about ETFs?
As I said earlier, ETFs provide an easy, low-cost, way to invest in a well-balanced pool of assets that can be traded at any time in the stock exchange. It is a tool that democratizes investing for average investors like you and me.
What do I mean by this?
Let me ask you a question – would you invest in Intel, Chevron, or Lockheed Martin?
The point is, most investors wouldn’t know the answer to that question. That’s the type of information that institutional investors with large amounts of money to invest would have, but not the average investor.
So, how can average investors safely invest in high-value companies with high yields?
A clear answer is by investing in ETFs – And, you don’t need to overanalyze those stocks because the beauty of the ETFs is that they follow an index, so it is the index that you pay attention to.
When it comes to price, the value of an ETF is calculated by adding the value of all securities in the fund, minus all liabilities, and then divide by the total number of outstanding ETF shares.
The result is the NAV (Net Asset Value) and this number is published every 15 seconds in the stock exchange.
Conversely, Mutual Funds’ NAV value is calculated once per day, at the end of each day.
As the popularity of ETFs continues to increase, it is important to understand what type of ETFs is more suitable for you. Let’s take a look at some of the types of ETFs available.
Market ETFs are designed to track active markets such as the S&P 500 or the NASDAQ; the purpose of ETFs is not to outperform an index but rather to mirror its’ performance.
These type of ETFs track and invest in essential commodities including agricultural goods, natural resources, or precious metals like gold, silver, or oil. When you invest in an ETF that holds gold securities, you are investing in gold without holding the physical bullion.
Bond ETFs are still attractive for many investors because of their ability to provide access to numerous types of bonds from the US treasury to international types of bonds.
The majority of ETFs are from the USA, but there are many attractive foreign options. Some Foreign ETFs provide great profits, so local investors don’t want to waste the opportunity.
For instance, in 2019 Asia ETF iShares Asia 50ETF AIA was up 18.8%, while iShares MSCI Emerging Markets ETF EEM was up about 13.4%.
Actively managed ETFs have fund managers who makes sector allocation changes and deviate from the index as they see fit; the goal of actively managed ETFs is to outperform the underlying index.
Imagine buying a basket filled with chocolates and other goodies. The price of the basket reflects the price of each item inside the basket. If the price of the items contained in the basked changes, so should the value of the basket.
It works the same way with ETFs. Here are three simple steps that explain this concept:
The ETF seller makes ETFs with a basket of different securities in it.
Investors buy ETFs similar as when you buy mutual. Just like a mutual fund, what you’re really buying is the underlying securities that the ETF holds.
You can hold or trade your ETFs in the stock market at any time of the day similar to how you trade stocks.
Another good thing of ETFs is that they don’t incur annual capital gains like mutual funds do. You only pay taxes when you sell your shares in the ETF for a profit. It’s no wonder why ETFs have become an important investment tool.
The price of an ETF equals the value of the underlying securities (known as Net Asset Value or NAV). However, during market hours several factors will influence an ETF’s price, including price movements of underlying securities, and investors’ demand for the ETF.
Invertors’ expectation of how securities will perform during the day plays a big role in the intraday bid and ask price. This influences demand, and thus the price of what ETFs trade at during market hours.
Thus an ETF NAV price may deviate from the ETF market price, especially during high volatility periods.
Let’s see what are the main advantages and disadvantages of investing in ETF.
In simple words, the advantages of investing in ETF are instant diversification, lower costs, liquidity, tax efficiency, and the ability to invest large as well as small amounts of money. Let’s review these one by one.
There numerous ETFs investors can choose from allowing investors the ability to invest in all major sectors, industries, high yield, or low yield.
While it is impossible to buy or invest in all the elements of a particular basket, ETF provide the advantage of diversification across sectors covered by the ETF.
With most ETFs there is no need to employ sophisticated investment managers to perform investment decision; that’s because ETF mirror the moves of a particular index, which result in lower fund fees.
For example, according to research conducted by Morningstar Investment the average ETF has an expense ratio of 0.44% vs. 0.74% for traditional index funds. That means the average ETF costs $4.40 in annual fees for every $1,000 you invest vs. $7.40 for index funds.
One of the key benefits of ETFs is that they offer better transparency than mutual funds. ETFs trade in the stock market; so you can check the price, trends and holdings at any time of the day. All you need is internet access and the sticker code.
For example, if you go to www.ishares.com, you can check the complete holdings for almost every ETF in the world.
By contrast, mutual funds only disclose their holdings in their quarterly reports, which means that in between periods, investors cannot check if the fund has taken in more risk, or if it’s losing money.
ETFs are more liquid than mutual funds because you can trade ETFs throughout the day, as long as the stock market is open. You can simply log in to your brokerage account and execute a trade yourself, or contact the brokerage to have them do it for you.
On the other hand, mutual funds are only traded at the end of each day.
With mutual funds, when fund managers sells part of the portfolio at a profit, all investors of the mutual fund receive a distributed portion of the capital gain; this means you get stuck with a tax bill even though you did not sell your mutual fund units.
ETFs are a lot more tax efficient than that.
You only pay capital gain if you sell your own ETF investment. When another investor redeems their position causing the ETF to redeem shares, another investor buys; no fuss, no muss, no capital gain.
The more you trade, the more fees you pay. Like stocks, ETFs pay small trading commissions with each trade. When multiple trading occurs, those trading fees add up to a significant amount.
The good news is that some brokerage firms have reduced their commission fees and others go as far as offering no fees.
May be Difficult to Find the Buyers of a particular ETF
Just like securities, the value of an ETF depends on the bid and ask price. Finding a buyer for less popular ETFs can sometimes become a challenging task.
ETFs That Are Focused on a Specific Niche
Most ETFs are focused on a specific type of index, for example, many ETFs track technology related indexes. This leads to greater price variation of a particular ETF compared to the bigger market index like the S&P 500.
There is more than one way to choose from to invest in ETFs such as online brokers, Robo-advisors, or standard brokerage firms. You can buy ETFs almost anywhere you can buy shares, but to start you will need a brokerage account.
Some brokerages, including Schwab and Vanguard allow you to trade ETFs without charge a commission. Others such as TD Ameritrade, Fidelity, and E-Trade also allow you to use third party providers without paying any commission on EFT trades.
Step 1: Pay attention and compare trading fees because those fees can add up to significant amounts that can diminish your returns.
Step 2: Building a diversified ETF portfolio. Simply buying an ETF does not translate into having a diversified portfolio. For example, if an ETF only has technology stocks in its portfolio that means you might be overexposed to technology stocks.
Broadening your exposure across different asset classes minimizes market risk. Thus, owning ETFs that have stocks, bonds, and other assets with companies of different sizes, in different sectors, and different geographical locations will go a long way in building a well-diversified portfolio.
Most ETFS are tax-efficient, especially the ones that track a major index; however, some ETFs that trade often will generate capital gains costs. So make sure you plan for tax consequences.
The best way to find the right ETF to invest in is by focusing in its attributes.
Tips for selecting the right ETF
Index Focus ETF
When it comes to ETFs, bigger is often better. ETFs that track big indexes such as the S&P 500 are typically better than ETFs that track smaller sectors like commodities.
Here are some useful rules of thumb about good ETFs:
Income Focus ETF
Income focused ETF aim to provide the highest yield. These funds typically would invest in other ETFs to gain exposure in a wide range of markets.
It’s also important to pay attention at the fund size, type of fees they charge, and how close the fund is designed to follow a particular index.
Here are some important elements you should learn about an ETF:
Risk averse investors would likely choose to invest in ETFs that has a high weight on bonds vs. stocks.
On the other hand someone seeking faster growth might choose 70% stocks and 30 bonds, or for a balanced approach you can even go 50% bonds and 50% stocks.
However, for stocks, remember that the more sectors you invest in the better diversified your portfolio will be.
The main differences between ETFs and mutual funds are the way in which the trades happen, the cost, diversification and tax attributes.
Ability to trade stocks in the stock market
With mutual funds, whether actively managed or index funds, you can buy and sale only at the end of the day.
Conversely, you can trade ETFs throughout the day as long as the stock market is open.
That is one huge difference!
For instance, imagine that your portfolio includes shares of aircraft maker Airbus. You just learned that an Airbus plane crashed over the pacific a few hours ago, and preliminary reports state the cause of the crash is attributed to engine failure.
You hear the news, open your computer and dump your ETF investment; by the end of the day, Airbus stock went down 10% so you’re glad you sold your ETF in time to avoid losses.
With mutual funds, you’re stuck holding that position until the end of the day.
Cost – ETFs Fees vs. Mutual Funds Fees
Actively managed mutual funds charge fees that are a lot higher than ETF fees.
With actively managed mutual funds, the fund needs to hire fund managers, investment advisors and a team of employees to help manage the fund. You’re paying for their expertise.
ETFs follow an index, so there is no need for a team of employees to manage Exchange Traded Funds (ETFs). This results into less costs incurred on ETF investments.
For example, according to Morningstar, the expense ratio for ETFs is 0.57% vs. 1.09% for actively managed mutual funds. That’s too high a difference to ignore, isn’t it?
Diversification options – ETFs vs. Mutual Funds
When it comes to diversification, there are more similarities than there are differences between ETFs and mutual funds.
They both bundle a wide range of assets such as stocks, bonds or other securities which make it easy for investors to build a well-diversified portfolio.
However, with an ETF you can get there a lot faster and easier than with mutual funds, and for a fraction of the cost.
Tax Attributes – ETFs vs. Mutual Funds
According to a survey conducted by the Financial Planning Association, ETFs are more tax-efficient and less expensive than Mutual Funds.
The way it works with mutual funds is the money the fund makes is distributed to unit holders, which results in tax liabilities for investors to pay. Those earnings could be interest from bonds, dividends or capital gains from the sale of shares.
It all gets distributed to fund holders and this money generates tax costs even if the investor reinvests the earnings right away.
As for ETFs, reinvested capital can be added to the adjusted cost base (ACB) on shares.
ACB = Purchase price (including commissions) + Reinvested distributions – Return of Capital
This means reinvested capital will not pay taxes for the year. You pay taxes when you sell your ETFs investment.
Also, with a mutual fund, if a shareholder wants to redeem his or her holdings, the fund has to sell the securities to generate money to pay the shareholder; this results in capital gains that are then distributed resulting in tax costs.
ETFs don’t experience this requirement; if a shareholder wants to redeem their position, another investor buys in, which results in an exchange in-kind. No capital gain.
Online brokers play an important role in ETF markets.
Online brokers offer and fast and easy way to invest in ETFs. Here is a list of the best online brokers to choose from:
This brokerage lowered their commission for all ETFs they offered to zero. They also offer a wide array of education materials and user friendly tools investors can use to make their investment decisions.
Fidelity has perhaps the most complete tools to learn about ETFs. Also the commissions they charge are competitive with top brokerage firms like Charles Schwab or TD Ameritrade.
TD Ameritrade is a great option for beginner ETF investors. You can trade using their platform without paying commissions as long as you hold the ETF for at least 30 days.
Vanguard group is one of the market leaders in ETFs; they offer tools that allow investors the ability to compare ETFs fees, performance, and expense ratios over a wide selection of ETFs.
An ETF is an Exchange Traded Fund, a form of fund that can be bought and sold in the stock market like shares. They are designed to follow the trade movements of a particular index like the S&P 500.
This means investors can build well diversified portfolios with a few simple ETF trades, while keeping the transparency and liquidity that trading in the stock market offers.
Thus, ETFs investments have grown exponentially and will continue to be part of the investment universe for years to come.