What are Exchange-Traded Funds (ETFs)?
An exchange-traded fund (ETF) is a security that combines a collection of other securities – such as stocks – that follow an underlying index. They are named as such due to the fact that they are traded, bought and sold on the market exchanges similar to stocks. ETFs provide an easy access to diversifying a portfolio as it is exposed to a wide set of asset classes.
The SPDR S&P 500 ETF is a well-known fund that tracks the S&P 500 Index. This fund is highly liquid and has high volume during market hours allowing you to buy or sell almost instantly after placing an order.
ETFs can contain a variety of investments like stocks, commodities, bonds or even a mix of investment types. Generally they can be easily bought and sold.
How do they work?
ETFs are specially designed to track the price of an index or collection of underlying assets as close as possible. A financial firm purchases a bundle of assets, whether that may be stocks, bonds, currencies, or commodities, which comprise the fund. The firm directly sells shares which track the value of that fund, through exchanges. They can be traded on the market just like any other stock.
Buying a share in an ETF does not mean you own a portion of the underlying assets, rather the financial firm running the ETFs own the assets and adjust the shares outstanding in an effort to keep the price in sync with the value of the underlying assets.
Types of ETFs
There are ETFs for almost any kind of security or asset in financial markets. They can be used for generating income, speculation, price increases, or to hedge positions to offset risk in an investor’s portfolio.
- Industry ETFS. Industry ETFs track a particular industry such as retail, mining, or the technology sector.
- Bond ETFs. Bond ETFs could include government bonds, corporate bonds, and state and local bonds (municipal bonds). These ETFs may invest in treasuries of a certain maturity, high-grade debt or junk bonds.
- Commodity ETFs. Commodity ETFs invest in commodities including crude oil or gold.
- Currency ETFs. Foreign exchange/currency ETFs invest in foreign currencies of one nation or even an entire region. Examples include the Pound or the Euro.
- Inverse ETFs. Inverse ETFs earn money from stock declines by shorting a stock. Shorting means selling a stock and buying back at a later time, making money if the stock price declines.
ETFs can be be ultra-wide or narrow as it could track a huge index like the S&P 500 or even a smaller group of companies in a sectors. Examples of ETFs include $SPY which tracks the S&P 500, $QQQ which tracks the Nasdaq 100, $IWM which tracks the Russell 2000 small-cap index, or the $DIA which tracks the Dow Jones Industrial Average.
Advantages of ETFs
- Low-cost, low-fee investments
- Instant diversification
- Easy to trade on an exchange
- High levels of transparency on assets and holdings.
- Exposure to alternative assets
- Tax efficient
Cons of ETFs
- Some ETFs may experience lower liquidity, making them harder to sell
- ETFs can close, forcing you to sell an investment earlier than expected
- Some ETFs have tracking error: Share prices may diverge excessively from the prices of underlying assets or indexes
- While you can trade throughout the day, some trades may require extended periods to settle
An ETF is more tax-efficient than a mutual fund as buying and selling happens through an exchange. The ETF sponsor does not need to redeem shares every time a transaction occurred. They are taxed similar to underlying stocks, where holding for more than a year would subject you to long-term capital gains tax rate versus the short-term capital gains rate.
Holding ETFs that consist of precious metal would make you be taxed at the collectibles rate. Holding ETFs with the energy commodity (oil and gas), you will receive a K-1 form since it is structured as a limited partnership.
It is important to understand the tax implications before purchasing an ETF.
For new investors, it is wise to not put all your eggs in one basket. Diversifying investments with a wide variety of securities and assets can help protect capital when an entire sector is being outperformed by another.
The concept of ETFs allow for an easier way to invest in an entire sector or index without risking too much capital. ETFs allow you to invest in commodities, precious metals, currency, and stocks just by purchasing ETF shares.
It is important to remember that owning a share of an ETF is not the same as owning the actual commodity. ETFs should be added to your portfolio to add diversity and to help meet your specific goals. It reduces risk without having to worry about buying a bunch of different stocks.