What is an ETF?
An exchange-traded fund (ETF) is an assemblage of securities that works just like a mutual fund but which investors can trade over a stock exchange. An ETF is a fusion of a stock and a mutual fund. The fund often tracks an index of securities, and it can be issued on almost all asset classes in the capital markets.
An ETF structure is essential to investors because it provides exposure to numerous securities without actually buying a piece of every single one of them. Issuers buy into target securities and then allow investors to buy a fund like they would buy a stock.
How do ETFs work? The first step to leveraging the profit potential of ETFs is to understand how they work. From this knowledge, investors can tell what ETF to buy, when, and in what quantity.
Briefly, ETFs work in three steps:
- An issuer assembles an asset’s units, say technology equities, into a basket that then acquires a unique identifier (or ticker) similar to stocks.
- The ETF is then listed on a major exchange from where investors can access.
- Just like a stock, investors buy and sell the ETF over an exchange during the day when the market is in session.
Types of ETFs
When creating an ETF, issuers have their mind on a particular asset class, an industry, sector, or even a trading style. It translates into different types of ETFs as described below:
- Industry/sector ETFs
The stock market classifies companies into sectors/industries using the Global Industry Classification Standard (GICS). The system develops an industry taxonomy that enables easy navigation of the capital markets, while issuers took advantage of the many sectors and sub-sectors to create unique ETFs. For example, consumer-staples ETF bundles together stocks of companies operating in the consumer staples sector.
- ETF for Stocks
Stocks are the largest asset class in the capital markets. One can easily guess, therefore, that ETFs on stocks are the majority. Moreover, the stock market’s vastness allows issuers to create numerous ETFs that focus on stocks from specific sectors. Stocks ETF comprise of shares in listed companies. Often, issuers track an index like the S&P 500 – whereby they draw stocks that constitute the index – or track a market-cap-weighted index.
- ETF for Futures
These ETFs comprise holdings in futures contracts. Futures contracts are mostly developed with commodities as underlying assets, although futures of other asset classes also exist, just like stock ETFs, futures ETFs track futures indexes.
- ETF for Commodities
Commodities such as crude oil are raw products that can be traded in the open market. Such an ETF could have various commodities as holdings or might focus on a single commodity. Some commodity ETFs include futures contracts, so you must know the finer details before buying into it. Also, the IRS classifies commodities into collectible and non-collectible. Each category has a different tax structure as well as a unique risk profile.
- ETF on Bonds
Bond ETFs usually track bond indices and benchmarks. Often, bonds are not readily available because they are traded over the counter most of the time. Creating bond ETFs, therefore, enables more investors to access the asset class via brokers. Historically, bonds have been available to institutional investors because of a lack of price transparency and access. Bond ETFs have changed this in that all investors can access current and historical prices of this asset class. Besides, investors do not have to hold bond ETFs until maturity, which is the norm with bonds.
- Inverse ETFs
Inverse ETFs track sectors, markets, and indices but in the opposite direction. An inverse ETF that tracks the S&P 500 will gain in value when the index falls. The same is true for inverse ETFs that track specific sectors. In short, an inverse ETF profits when the underlying index or market declines. An inverse ETF behaves similarly to the performance of a position of an investor who shorts an index/market.
- Leveraged ETFs
Leveraged ETFs take the concept of tracking indices and markets a notch higher. Regular ETFs track securities in the underlying market/index one-to-one, meaning the profit gained increases at the same pace as the underlying market/index value. On the contrary, leveraged ETFs amplify the profits by use of debt and financial derivatives. Instead of 1:1 ratio, leveraged ETFs aim for higher ratios like 2:1, 3:1, or higher.
What’s against Mutual Funds?
Mutual funds are an attractive alternative for investors who would like to counterbalance the weight of growth stocks in their portfolio. But mutual funds fall short when juxtaposed with ETFs. In the first place, mutual funds charge a higher expense fee compared to ETFs. On average, US ETFs’ expense ratio is 0.53%, as opposed to 1.42% for US mutual funds. Because of this, ETFs earn investors a more significant profit than mutual funds.
Another difference between mutual funds and ETFs that make the latter more attractive is tax efficiency. Generally, mutual funds register more turnover relative to ETFs. The higher frequency of buying and selling in mutual funds leads to capital gains, which is taxable. The passive nature of ETFs means that they do not accrue capital gains.
Moreover, ETFs are tradeable on exchanges, meaning investors can access them easily. Also, there is plenty of information available about the historical and current prices of ETFs. When you decide to buy an ETF, you are likely to make a better choice because you know enough. Mutual funds, on the other hand, provide shares that are untradeable on an exchange. Therefore, liquidity when talking about MFs is a big challenge.
The bottom line
An ETF expands the options range for investors to earn from the securities market. Besides, they make securities investment less risky and more stable. ETFs provide exposure to various securities without having to own every single item in the basket. All you need to do is buy an ETF off-exchange, and there you have interests in hundreds of securities.
There are numerous types of ETFs. ETFs could be sector-specific, security-specific, index specific, market-specific, or even focus on a particular trading style. Inverse ETFs allow traders to profit from declining markets. Overall, ETFs are better than mutual funds because they are inexpensive, highly liquid, and easily accessible.