What is an ETF?
Important Benefits of ETFs
An ETF typically represents a collection of hundreds, perhaps thousands of shares, or bonds. They are managed by financial services experts from companies that own assets, including shares, commodities, and derivative instruments. ETF fund managers divide asset holdings in the fund into individual shares. These offer shareholders specific benefits such as dividends and voting rights. ETFs can be traded OTC (over-the-counter), or through a stock exchange.
ETF categorizations cover a wide range of possibilities, including fixed income equities, commodities, real estate, bonds, indices, regions, or sectors. By investing in an ETF, it is possible to focus on a wide range of different investment options each of which falls under a specific investment type. These funds are offered across a range of asset classes, encompassing traditional investment options, currency pairs, commodities, et al. With ETFs, traders, and investors can short financial markets, enjoy tax benefits, and gain leverage in the markets. There are also low fees and commissions associated with ETFs.
ETFs came to prominence in 1993 with the ticker SPY, designating Spiders. This particular Exchange Traded Fund has the auspicious title of the largest volume ETF ever. In US stock exchanges alone, ETFs amassed a total market capitalization of $5.83 trillion in 2021. According to stats, some 2200+ ETFs currently trade in the US, with many more at international exchanges.
ETFs vs mutual funds
ETFs are usually passively managed funds. Mutual funds are actively managed by the fund managers. In other words, the constituent components of mutual funds can be reorganized and traded regularly. Bear in mind, ETFs and mutual funds share many similarities. Since they both represent a managed basket of individual shares or bonds, they present as less risky than individual stocks and bonds. Both ETFs and mutual funds offer investors a variety of options, with low commissions and fees.
The market price of an ETF is the cost of one share. This is much lower than the cost of a mutual fund which typically costs thousands of dollars. With ETFs, traders and investors enjoy real-time pricing, and there are a wide variety of order types available. Market orders, limit orders, stop orders, stop-limit orders, and short sale orders are available with ETFs. The majority of ETFs are index funds known as passive investments. Expect tight spreads, low costs, and low initial investment amounts with ETFs.
With mutual funds, there are much higher capital gains taxes. Mutual funds have a one price fits all mechanism. Regardless of the time of day you purchase a mutual fund, you pay the same price on the day. Prices are determined at the close of the trading day. The pricing on ETFs is dynamic. Prices change throughout the day, and commissions are usually charged on transactions executed during the trading day.
Different Types of ETFs
There are 6 main types of ETFs:
Style-based ETFs are determined by the ETF fund manager rather than an instrument type or a market segment. These ETFs track specific investment styles or asset classes. There are small, medium, and large-cap stocks available. Investors can focus on value vs growth, high risk vs low risk, or capitalization size. These are the preferred financial instruments for diversifying a portfolio. An example is the IWM style-based ETF with a focus on shares in the Russell 2000 small-cap index.
Dividend ETFs usually hold shares of companies with a history of paying dividends to shareholders. It is worth emphasizing that there are no guarantees on dividend payments, unlike coupon payments on bonds. With dividend ETFs, you get to enjoy a diverse portfolio of assets, the potential for regular revenue streams, and continued payouts even if company earnings diminish. Many examples of dividend ETFs are available, including SPDR S&P Dividend ETF (SDY), the Vanguard Dividend Appreciation ETF (VIG), or the iShares Core High Dividend ETF (HDV).
Sector ETFs own shares in companies featuring similar products and services or companies that are engaged in similar types of business activity. There are many types of sector ETFs, including utilities ETFs, consumer staples ETFs, consumer discretionary ETFs, healthcare ETFs, technology ETFs, energy ETFs, and real estate ETFs. For example, XLV Healthcare Select Sector SPDR Fund has 100% of its shares in the healthcare sector.
With currency ETFs, it is possible to track a single currency index or a basket of currencies. The benefits of currency ETFs are portfolio diversification, speculating on exchange rates, and hedging non-dollar liabilities. The EUO ProShares UltraShort Euro Currency ETF includes a basket of currency forwards from cash assets, Goldman Sachs, and UBS. This particular fund has an expense ratio of 0.95%.
With commodity ETFs, investors can dabble in precious metals, energy, or agricultural goods through futures contracts, or with metals held in secure storage vaults. There are many examples of top-performing commodity ETFs such as SPDR Gold Shares (GLD), or iShares Gold Trust (IAU). These futures-based ETFs are contracts that are traded on exchanges like bonds and stocks. All ETFs group together shares from similar stocks, sectors, or industries
Bond ETFs invest in corporate and government bonds. The main advantage here is that the fund managers will use a set of investment strategies (including early closure where possible) and differing maturity dates to maximise regular returns. The iShares TIPS Bond ETF owns a variety of US treasury bills with different face values and maturity lengths.