Exchange traded funds or ETFs are a type of investment fund which are traded on the stock market. ETFs are very similar to mutual funds but the main difference is that ETFS are traded within the owners or holders of these ETFs and mutual funds are bought and sold from the issuer according to the price of the day. ETFs offer a wide ranged basket of assets which is meant to replicate an index and offers minimal management cost and more intraday transparency. An ETF holds assets ranging from stocks, bonds, currencies, to commodities such as gold bars. Most ETFs are index funds, meaning that they hold the same securities in the same proportions as a certain stock market index or bond market index.
An ETF divides ownership of itself into shares that are held by shareholders. The details of the structure (such as a corporation or trust) will vary by country, and even within one country there may be multiple possible structures. The shareholders indirectly own the assets of the fund, and they will typically get annual reports. Shareholders are entitled to a share of the profits, such as interest or dividends, and they would be entitled to any residual value if the fund undergoes liquidation.
ETFs may be attractive as investments because of their low costs, tax efficiency, and tradability.
As of August 2021, $9 trillion was invested in ETFs globally, including $6.6 trillion invested in the U.S.
Closed-end funds are not considered to be ETFs, even though they are funds and are traded on an exchange. Exchange-traded notes are debt instruments that are not exchange-traded funds.
To analyse further, let us look into some of the advantages that these ETFs hold
Advantages
Diversification
The biggest upside in choosing an ETF is that an ETF is spread across a wide variety of instruments. An ETF will be a combination of stocks, bonds, commodities. These instruments are spread across a variety of market segments. The instruments covered in an ETF can also be a combination of instruments from different countries. ETFs are also traded on virtually every major asset class, currency, and commodity in the world.
Low Cost
ETFs have much lower expense ratios than traditional mutual funds. This is because ETF shareholders are not mandated to pay for the team of managers, analysts, and brokers to trade funds on their behalf or manage the fund’s inflows and outflows.
Flexibility in Trading
ETFs are easy and convenient to trade just like a single equity stock but it offers the element of diversification that the later does not.
You can purchase ETFs on margin and sell short; their prices are updated as and when they move giving you the opportunity of selling or buying at the opportune moment. This is a significant advantage over mutual funds that are open-ended and the prices of which are available at the day’s end on NAV or net asset value; ETFs allow risk management through futures trading and options, similar to stocks; As they trade like stocks, ETFs allow you to monitor daily changes of the commodities sector by way of a ticker symbol.
The trading flexibility that comes with ETFs gives their investors the added benefit of taking timely decisions on their investments and placing their orders in numerous ways. When you invest in ETFs, you have all the trade combinations characteristic of investing in equity stocks and these include limit and stop-limit orders. You can even purchase ETFs on margin after taking a loan from your broker. You can even short sell by borrowing securities from your broker and selling these securities simultaneously. This is usually done with a view to buy them back when their prices drop later.
Liquidity
ETFs are traded on exchanges, meaning you can buy and sell ETFs throughout the day. In other words, investors who want to sell an ETF and get their profits can do so quickly and at a fair price. In contrast, something like buying a house can be considered a less liquid investment as it would take longer to find someone willing to buy your property and you might need to accept a significant discount if you ever need to sell it quickly. This characteristic makes ETFs a useful tool for an investor who wants to quickly move in or out of a market.
Accessibility
ETFs tend to have very low minimum investments meaning you don’t need to have a lot of money to get started! You can start building a portfolio of ETFs with just a few hundred and top up as you go.
Draw backs of ETFs
Here are some of the draw backs which you need to account for before investing in these ETFs.
Tracking errors
Although an ETF manager will try to keep their fund’s investment performance aligned with the index it tracks, that may be easier said than done. An ETF can stray from its intended benchmarks for several reasons. For instance, if the fund manager needs to swap out assets in the fund or make other changes, the ETF may not exactly reflect the holdings of the index. As a result, the performance of the ETF may deviate from the performance of the index.
This issue, along with others, can create tracking errors, or the difference between an investment portfolio’s return and the return of a chosen benchmark. That means an ETF could wind up costing more than the underlying assets, and an investor might actually pay a premium when buying that ETF. Fortunately, this is uncommon and is typically corrected over time.
Potentially less diversification
Many ETFs offer diversification because they contain hundreds or even thousands of securities within and across asset classes. But some ETFs are narrowly focused, concentrating on a particular sector of the market or a subset of an asset class. For instance, some funds focus on large-cap or small-cap stocks, a particular country, a specific industry, or a particular commodity.
Hidden risks
With so many ETFs to choose from, the mix of assets in a single fund can be vast or complex—and some may contain risky securities that might not be so obvious upfront. Additionally, ETFs can be affected by volatility just like any investment. That’s why investors will need to research what the ETF is tracking and understand the underlying risks.
Capital gains distributions
Some ETFs own dividend-paying stocks, which generate cash. On other occasions, an ETF might sell an asset at a profit that results in capital gains. The fund manager can distribute this money in two ways: pass the cash to the investors or reinvest it into the ETF’s underlying securities. Investors who receive cash but want to reinvest the money will need to buy more ETF shares, which creates new fees.
No matter how the ETF uses this cash or its source, shareholders are responsible for paying taxes. Every ETF treats dividends and capital gains distributions differently, so investors will need to research the fund’s policy before investing in it.
Lower dividend yield
Some ETFs pay dividends, but investors may receive higher returns on specific securities, such as stocks with large dividends. That is partly because ETFs track a broader market and therefore have lower yields on average. If an investor can take on the additional risk of owning certain stocks, they may receive higher dividends.
ETFS do make a good investment choice. But as an investor, one need to keep in mind their goal and financial plan when it comes to investing in any kind of financial instrument.
Comments