What Is an ETF and How Does an Exchange-Traded Fund Work?
What Is an ETF and How Does an Exchange-Traded Fund Work?
13 July 2022
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Exchange-traded funds (ETFs) are becoming increasingly popular investment instruments in the modern financial market. Offering the benefits of both stocks and mutual funds, they provide investors with trading flexibility and exposure to larger markets while being cost- and time-efficient. In case you have decided to add ETFs to your portfolio, here is a comprehensive guide that comprises all the necessary information about this trading tool: ETF types, how to trade them, their merits and drawbacks, and more.
What Is an ETF?
An exchange-traded fund or an ETF is a collection of underlying assets that can be traded on the exchange. This instrument combines the features of both stocks and mutual funds. Like individual stocks, ETFs are speculated during the trading day within the market hours providing investors with higher liquidity. Like mutual funds, they are considered to be efficient tools to diversify the investment portfolio due to numerous securities on its basis. An ETF can consist of many different assets such as commodities, stocks, bonds, a mixture of them, etc. When it comes to underlying stocks, they can represent one particular industry (e.g. energy, technology, services, etc.) or be a combination of shares from different spheres, be territory limited (e.g. stocks of the US companies) or have global coverage.
How Do ETFs Work?
An ETF is formed by fund managers or investment companies who own the underlying assets and want to keep track of their behavior. Once created a fund they offer its shares to investors who can buy and sell them on the exchange during trading hours. Here are key ETF characteristics to remember:
Like company shareholders, ETF traders don’t own the whole basket of securities but only a part of it.
ETFs can be traded during the market and extended hours.
They can combine securities of different types (stocks, commodities, currencies, etc.).
Just like stocks, every ETF has its particular ticker (for example, SPDR DJIY, SPY, ICVT, etc.)
ETFs let investors get exposure to a larger market while opening only one position.
Types of ETFs
A strong technological boost along with high investor demand has contributed to the exchange-traded fund development and its increasing popularity. A big variety of ETFs can be divided into two large groups:
Passively traded ETFs are usually focused on the performance of a broad index, such as the S&P 500, the Dow Jones Industrial Average, etc.
Actively traded ETFs don’t track a certain index but let investors decide by themself on the selection of the securities in the portfolio. This type of ETF investment can result in potentially higher profits, however, it’s also associated with more expenses and more significant risks.
ETFs can also be grouped by type of investment. Let’s have a closer look at the six main components of this classification.
Bond ETF holds a basket of bonds as an underlying asset. It can include various types of these securities such as corporate bonds, convertibles, Treasuries, and others. Bond ETFs like any other type of exchange-traded funds are sold and bought on exchanges when the market is open. In contrast to individual bonds, they are more liquid and don’t have a maturity date, so it’s possible to sell them immediately after purchasing without any fees. This type of ETF is used by many traders to gain a fixed income which comes from the interest accumulated from the individual bonds in the basket. Some examples of bond ETFs include SPLB (a corporate bond ETF), ICVT (a convertible bond ETF), SCHO (a Treasury bond ETF), etc.
Stock ETF (also known as equity ETF) consists of various stocks commonly representing one industry (for example, technology, energy, etc.). In contrast to individual stocks, it allows investors to get exposure to the whole market sector by opening one position, thus, with significantly lower expenses. Stock ETFs are considered to be efficient long-term investments. The majority of them monitor the performance of industry benchmark indexes, thus, are referred to as indexed-stock ETFs. One of the most actively traded stock ETFs in the market nowadays is SPDR S&P 500 (SPY). It tracks the performance of the S&P 500 index.
Industry or sector ETF concentrates on investing in a particular industry. Global Industry Classification Standard (GICS) has defined 11 key sectors that can be widened to numerous industries and subindustries. Here are some of them:
This ETF type provides investors with an opportunity to enter a certain area of their interest while carrying significantly lower risks in contrast to investing in an individual company. Industry ETF examples include the XTN (Transportation ETF), XLE (the Energy ETF), the SMH (Information Technology ETF), etc.
Commodity ETF, as its name suggests, monitors the performance of a certain commodity or a combination of them such as precious metals (gold, silver, etc.), agricultural products (coffee, cotton, etc.), natural resources (crude oil, natural gas, etc.), and others. ETF investing in commodities offers traders a set of benefits. It’s cost-effective since investors don’t need to take ownership over the physical assets, meaning that they don’t have to pay for its storage and insurance. Moreover, they can still take advantage of commodity hedging abilities, protecting them from market downturns. The most popular commodity ETFs focus on precious metals and natural resources. The largest commodity ETF with $65.5 billion in assets is SPDR Gold Trust (GLD).
Currency ETF monitors the price fluctuations of a particular currency or basket of currencies on the foreign exchange (Forex). Like any other type of ETF, it lets investors get exposure to the whole market without having to open numerous positions. What’s more, it has proven to serve effectively various investment objectives: be it speculating, diversification, or hedging. Some of the popular currency ETFs include Invesco DB US Dollar Index Bullish Fund (UUP), Invesco CurrencyShares® Euro Currency Trust (FXE), and others.
Inverse ETF (also called short ETF) allows investors to potentially profit from market downturns. Trading this type of exchange-traded fund is very similar to shorting. Inverse ETFs make use of derivatives (e.g. futures) to let investors make their predictions about the possible asset price movements. If the asset price goes down, inverse ETF is going to rise in value proportionally, excluding the brokerage commission and some fees. This type of ETF is mostly used for short-term investments. The list of top inverse ETFs involves:
ProShares UltraPro Short QQQ (SQQQ) tracks the performance of the Nasdaq 100 index;
ProShares Short UltraShort S&P500 (SDS) provides exposure to the S&P500 index;
Direxion Daily Small Cap Bear 3X Shares (TZA) monitors the value fluctuations of the Russell 2000 index.
How to Begin Investing in ETFs
ETF is a quite easy-to-implement trading instrument suitable for both newbies and seasoned investors. Once you decided to try it out, all you need to do is to follow these steps.
Find an investing platform and open a brokerage account. Being a popular investment instrument, ETFs are present on many platforms. When opting for one of them, make sure it’s a trustworthy broker. What’s more, choose the platform that offers a wide range of trading tools that could facilitate and enhance your trading experience. Note that some platforms (such as Naga.com) comprise the features of educational and news resources, helping investors stay up to date and save time on finding the necessary information.
Research. ETFs like any other investment tools have their distinguishing features. To take full advantage of them and mitigate potential trading risks it’s crucial to learn more about their benefits, challenges, and various types.
Choose a suitable ETF. When choosing among numerous types of ETFs, it’s important to select one that will fits your trading style and goes well with the rest of your portfolio. At this stage, it’s important to clearly understand your investment goal (whether it is income or potential growth), define sectors that appeal to you, think of an acceptable level of risk, consider a trading strategy (long-term, short-term investments, etc.).
How to Buy and Sell ETFs
ETF investing is much similar to trading individual stocks. ETFs can be bought and sold on exchanges during market hours. However, one of their biggest advantages, making these assets appealing for new investors, is that they carry a lower level of risk due to the diversification feature. As mentioned above, the first thing you need to do before starting trading ETFs is to choose the platform and open the brokerage account. Then, the process of buying ETF is quite the same as buying stock.
You need to open the trading section on the brokerage platform and find an ETF you have previously chosen in compliance with your goals, strategy, risk management plan, etc.
Determine the investment amount and the lot size. It’s reasonable to place also the stop loss and take profit orders to mitigate possible risks.
Open your ETF trade and enjoy the potential benefits of a well-diversified portfolio.
How much do ETFs cost?
Various types of ETFs may come with different expenses. In general, ETF investing is known to have a lower expense ratio, in comparison to other types of trading (for example, mutual funds). However, to clear up how much it may cost, it’s necessary to pay attention to the following elements:
Operating costs include fees, taxes, and other expenses. ETFs stand out among other investment instruments with their significantly lower operating costs.
Commission costs. In the majority of cases, ETF trading is commission-free. However, it will be necessary to check your online broker regulations regarding this point.
Spread is the difference between the “bid” and the “ask” price that is paid for each trade. Thus, a growing spread along with frequent trading may result in considerable expenses.
Real-World Examples of ETFs
According to Statista, in 2020 there were around 7602 ETFs worldwide, 2204 of which were in the US. As of 2022, State Street’s SPDR S&P 500 ETF Trust is considered to be the largest ETF globally by market capitalization (about $397.9 billion). Some other popular examples of exchange-traded funds include, but are not limited to:
SPDR S&P 500 (SPY) formed in 1993 was the first ETF listed on the US exchange.
The Invesco QQQ (QQQ) monitors the performance of Nasdaq 100 and is focused on the technology industry.
USO is an example of a commodity ETF (crude oil).
GLD is a popular commodity ETF for gold.
Vanguard Information Technology ETF (VGT) is an example of an industry ETF.
iShares MBS ETF (MBB) represents a bond ETF.
Advantages and Disadvantages of ETFs
ETFs attract the attention of many traders mainly due to their cost-effectiveness, simple learning curve, and diversification ability. However, like any trading tool, they are prone to some pitfalls. This table will help you analyze ETF’s main pros and cons.
Low expense ratio.
In contrast to mutual funds and other investment instruments, ETFs imply less operating and managing costs. Moreover, they come with less or no broker commission.
In contrast to individual assets, ETFs are less liquid and may have potential issues when it comes to selling them.
ETF comprises a basket of various securities, that let investors diversify their portfolios without placing numerous trades. It’s an efficient risk management tool helping to hedge traders’ investments against sudden market movements.
Cost can be higher.
Compared to particular individual stocks ETFs may imply more expenses. This is not about brokerage commission, but management fees and higher spreads.
ETFs allow investors to get access to the whole industry, sector, or market while having only one position open.
ETFs are traded on exchanges during the trading day, providing investors with greater flexibility in buying or selling them.
Dividends and ETFs
Apart from potential trading returns, ETF investors can profit from dividends in case the underlying asset is dividend-paying. Exchange-traded funds offer two types of dividend distribution:
Qualified. These dividends could be paid on assets held by the ETF for more than 60 days throughout a 121-day period. Qualified dividends have to be taxed at a capital gain rate.
Non-qualified. Such dividends are payable on assets involved in the ETF for 60 or fewer days.
Depending on the ETF type, dividends can be paid monthly, quarterly, or following a different schedule.
ETFs and Taxes
ETF investing has proven to be tax-efficient. In contrast to mutual funds that create many taxable events when being sold, ETF managers don’t have to pay off the assets that traders sell or add new assets when traders want to buy. This way, ETF tax costs stay lower. In all the rest, ETF tax regulation is similar to mutual funds. They involve
capital gains, which can be divided into long-term (may range from 0% to 15%, or 20%) and short-term capital gains (from 0% to 37%). In the US to receive a long-term capital gain treatment, it’s necessary to hold the ETF position for more than 1 year.
dividends. Tax percentage depends on the dividend type. Qualified dividends are taxed using the capital gain rates while non-qualified dividends are taxed at income rates.
ETFs Market Impact
Although ETFs are growing in popularity among traders, experts have different standpoints about their influence on the financial market. Some skeptics believe that ETFs reduce market efficiency, foster volatility, and hinder diversification. However, this point of view is refuted by other experts and market researchers, insisting that ETFs don’t carry any harm since they still have quite small footprints on the market. Moreover, formed and developed in the right way, they can have a positive impact on the future market performance.
ETF Creation and Redemption
Creation and redemption is a special approach that controls ETF security supply. These processes involve Authorized Participant (AP) who can be a financial organization, financial expert, or anyone who obtains a significant buying power since the AP is the one who buys all the assets that an ETF is planned to consist of.
The process of ETF creation consists of the following steps:
When an ETF wishes to create new shares it turns to Authorized Participant.
If an ETF is index-based, AP acquires a particular amount of all ETF constituent shares.
AP sells or exchanges these underlying securities to the ETF sponsor, getting in return new ETF shares. The collection of securities used for this exchange is called the creation unit.
AP receives profit by selling these shares on the stock exchange.
Creation When Shares Trade at a Premium
ETF trading at a premium means that ETF shares value at the market closure exceeds the price of the underlying stock itself (called net asset value). Let’s consider an example. If the ETF monitors the performance of Nasdaq 100 and at the market close its share price is $92 in contrast to $90 of the underlying asset price, this situation will be defined as trading at a premium. To balance the ETF price to NAV, AP has to commence ETF funds creation by buying underlying securities. This process will increase the number of new ETF shares and stabilize their price.
Redemption is an opposite process. AP acquires ETF shares on the market and sells them to the ETF manager, receiving individual underlying stock that he may sell to get potential profit. The process of redemption can be presented in the following steps:
AP acquires ETF shares on the stock exchange.
AP distributes these shares to the ETF sponsor.
ETF sponsor provides AP with ETF underlying securities.
AP sells underlying assets on the market.
Redemption When Shares Trade at a Discount
Trade at discount occurs when the ETF shares have a lower value than its basket of underlying assets. Redemption can be an efficient tool to equilibrate this situation. AP buys ETF shares, decreasing their number on the market, this way, making their price grow and get closer to the net asset value.
ETFs vs Mutual Funds vs Stocks
ETFs have much in common with both mutual funds and stocks. However, they are not the same. Let’s have a closer look at their similarities and differences.
ETFs vs Mutual Funds
The main similarity between these two investment instruments is that they represent the basket of underlying securities (stocks, bonds, commodities, or a mixture of them). This leads to their two other common points - greater exposure to the market and a diversification opportunity, helping investors to mitigate potential trading risks.
The differences between ETFs and mutual funds are as follows:
ETFs trading happens on the exchange and during market hours.
Mutual funds can be bought or sold only once per day when the market closes.
ETFs are usually considered passive investments, although they can also be managed actively.
Mutual funds are usually managed actively.
ETFs are more tax-efficient due to their unique organization.
Mutual funds, especially actively-managed ones, imply a bigger turnover, thus, more capital gains. Therefore, they tend to be less tax-effective
ETFs vs Stocks
The key feature that unites ETF and stock is that they are both traded on the open market. What’s more, an ETF, having in its basket dividend-paying assets, like stock, may also provide investors with extra income from dividends.
When it comes to differences, here are the most significant ones.
ETF is an investment pool consisting of a combination of securities.
Stocks represent shares of one company.
ETFs help traders diversify their portfolios, this way, reducing potential risks.
Tracking the performance of only one company, stocks may be riskier.
ETFs come with no ownership of the underlying asset, but only a part of it.
Stocks imply physical ownership of the asset.
ETFs imply more tax benefits compared to either mutual funds or stocks.
Stocks are taxed at an income or capital gain rate.
What the Future Holds for ETFs
Although ETFs have already achieved widespread popularity on the financial market, according to many specialists, they will continue gaining more influence following rapid technological development. They stand out with lower costs, tax efficiency, liquidity, easier management, diversification abilities, and more. However, when considering adding ETFs to the portfolio, it’s crucial to remember that like any trading instrument they imply risk. Therefore, before doing any investment steps it’s necessary to conduct thorough preliminary research and learn more about exchange-traded fund features and their types.
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