Exchange traded funds have become quite popular these days, but what is an ETF exactly? With more than 1,600 ETFs in the US alone and approximately $2 trillion in managed assets, it’s only natural to want to learn about this emerging investment option.
In this article, we’ll examine the concept of an ETF, take a look at its advantages and disadvantages. We will also mention some of the top ETFs for 2017.
The Concept of an ETF
According to NASDAQ, ETFs have been available to investors since the early 1980s. However, they only really began growing in popularity within the last decade.
Aside from a few differences, an ETF is a lot like a mutual fund. One of these key differences is the fact that it trades on a stock exchange. Unlike mutual funds, which consist of a selected basket of securities, ETFs directly track the stock, bond, and commodities indexes. For example, an S&P 500 index fund or ETF would own all 500 stocks in that index.
So, when answering the question what is an ETF, simply put, ETFs are funds that track the Dow Jones, S&P 500, NASDAQ 100, and other major indices. When you call your broker or go online and purchase shares of an ETF, you’re essentially buying shares of a large stock, commodity, or bond portfolio that tracks the return and yield of an index. While other types of index funds try to outperform the index, ETFs simply replicate the index’s performance. Rather than beating the market, they actually are the market.
Since ETFs simply track a certain market index, they don’t require active management. Passive management provides ETF investors with a number of advantages. Actively managed funds require continual trading in an effort to perform better than the market. Passively managed ETFs only require managers to make small periodic adjustments to ensure the fund remains aligned with its index.
Most mutual fund investors interested in learning what is an ETF are often pleasantly surprised to learn this. ETFs only involve a select predetermined number of stocks. Mutual funds often invest in a continually changing number of different stocks based on analysts’ projections. With these facts in mind, it’s safe to say ETFs involve less managerial risk.
In other words, an ETF investor doesn’t need to worry about picking the right fund manager, only the right fund. When you purchase shares of an ETF, you’re betting for or against the market itself. Yes, you read that right. Since ETFs are traded on exchanges, investors have the flexibility of opening both long and short positions. But we’ll get into this and other ETF advantages below.
Advantages and Disadvantages of an ETF
If you’re wondering what is an ETF, it’s important to know that an ETF has both the features of a stock traded on an exchange and an index fund. As you now know, an ETF is a package of a number of stocks. They correspond to an index that sells as a single entity. Similar to a stock, an ETF can be bought or sold anytime during a trading day.
Today, there are hundreds of ETFs regularly traded on the major exchanges. Like any investment vehicle, there are both advantages and disadvantages of investing in an ETF. Smart investors make sure they fully understand what is an ETF. They also consider both the pros and cons before investing their hard-earned dollars.
Advantages of ETFs
• Liquidity – Like stocks, ETFs are highly liquid and allow investors to sell their holdings and easily receive funds from the sale.
• Diversification – A single ETF can provide you with exposure to a diverse group of equities. It can track a wide-range of stocks and mimic the returns of an entire index or even a country.
• Low Fees – ETFs have passive management and require less attention. This gives them much lower expense ratios than actively managed mutual funds.
• Trades Similar to a Stock – Although ETFs provide investors with the many benefits of diversification, they trade just like stocks. In addition to their ability to be purchased on margin, they can also sell short. Also, they trade at prices that are continually updated throughout each trading day.
• Dividend Yields – Similar to stocks, some ETFs also pay dividends. While the risks associated with trading ETFs is lower than that of stocks, dividend yields for ETFs tend to be lower. This is a reflection of this reduced risk.
• Tax Efficiency – With ETFs, securities are not actually buying and selling. Therefore, there is no capital gains tax liability. In fact, in most cases, the only time investors face capital gains taxes is when an ETF must sell some of its shares. Nonetheless, an investor should consult with a tax accountant or attorney for tax advice.
Disadvantages of ETFs
• Possibility of Financial Loss – Like stocks or any other type of investment instrument, ETFs fluctuate in price. Therefore, while the Dow Jones, S&P 500, and many other indices tend to track up over the long-term, the chance of losing money is always a possibility. This is important to understand if you have an interest in learning more about what is an ETF and hoping to profit from these unique investment vehicles.
• Varied Risk – Some ETFs use leverage to inflate gains and some hold poor quality bonds. Therefore, there is a wide variety of risk to calculate when deciding on which fund to trade.
With the rise in popularity of exchange traded funds in recent years, many investors looking to maximize their gains and minimize their risk find themselves asking “What is an ETF?” In short, ETFs are one of the best investment products for individual investors. When used wisely, they’re a superior vehicle to help achieve an individual’s investment goals. With the ability to trade a wide-range of investment assets, use leverage, short markets, and avoid capital gains taxes, every investor should consider adding ETFs to their investment portfolio.