An ETF, or exchange-traded fund, is an investment fund that trades on an exchange and tracks an index or a basket of assets. An ETF can be thought of as a listed company that’s only function is to own other assets. ETF investing is the cheapest method to invest effectively.
ETFs are bought and sold on an exchange like and other listed shares. This differs from mutual funds that an investor buys from the fund management company, and sells back to the company when they wish to divest.
Exchange traded funds track a benchmark rather than trying to outperform a benchmark. That means that ETF investing falls within the realm of passive management.
Advantages of ETF investing
ETFs have grown in number and size since 2000 since it emerged that most active managers underperform their benchmarks. Actively managed funds charge higher fees than ETFs, and since an actively managed fund is unlikely to outperform its benchmark, there is little point in paying more.
ETFs offer a simple and cost-effective method to invest in the stock market. ETFs also offer diversification that would be expensive to achieve by building a portfolio of shares.
An ETFs can be used to build a portfolio of investments to suit an investor’s needs. ETFs with exposure to different asset classes, regions and sectors can be combined to achieve very specific goals.
The lower costs also allow investors to switch between different sectors as market conditions change.
As of 2016, there were over 4,700 ETFs listed around the world. The largest ETF is the SPDR SPY ETF which tracks the S&P500 index and has assets under management of $212 billion.
The largest ETF issuers are BlackRock, Vanguard, StateStreet, Invesco and Charles Schwab. These five issuers account for nearly 90% of the US market.
ETFs vs. Mutual Funds
Most mutual funds (though not all) are actively managed – in other words, the fund manager actively decides which securities to hold in the fund. ETFs usually track an index and hold exactly the same securities as that index.
Mutual funds on average charge higher management fees than ETFs. Mutual funds also sometimes charge upfront fees when the fund is purchased. ETFs charge management fees and shareholders also pay brokerage to a stock broker when they buy and sell their ETFs.
Mutual funds are bought and sold at their NAV, or net asset value. That means when a client buys a mutual fund they pay the exact value of the underlying investments in each unit, plus fees. When they sell that mutual fund, they will receive the NAV in return. ETFs are traded on an exchange, which means the traded price can be different from the NAV. The bigger the ETF is, the lower the difference between the market price and the NAV usually is.
Types of ETFs
The simplest ETFs track basic stock indices like the Dow Jones Industrial average and the S&P500 index. Sector ETFs track indices that follow specific sectors of the market. Currency and commodity ETFs follow indices like the Dollar Index and the CRB commodity index.
Smart Beta ETFs track specifically designed indices that try to avoid some of the weaknesses of market cap weighted indices. They may, for instance, limit the maximin weight of any one share in the index. Or they may use fundamental data to weight a stock, or they may simply weight each stock equally.
Over the years, ETFs have become more and more exotic, and these day’s if you can imagine a theme for an ETF, it probably exists. There is an ETF that tracks companies in the organic food business, an ETF that tries to copy hedge fund trades and a merger arbitrage ETF. And, there are ETFs that provide three times the return of an index – whether it’s positive or negative. There are also ETFs that track the volatility of an index.
These exotic ETFs may sound exciting, but its best to stick to simple products until you understand the risks involved in exotic instruments.
Understanding the Costs
While ETFs are the about the cheapest way to invest, they are not free. These are the costs associated with ETFs:
- The issuer deducts an annual fee from the holdings of the fund – this covers the expenses incurred in running the fund and the issuer’s management fee.
- When you buy or sell an ETF, you pay commission to a stock broker.
- The bid-offer spread is also a cost. Bigger ETFs tend to have lower bid-offer
The total expense ratio is the management fee and expenses that are deducted. Sometimes this is fixed, and sometimes it is variable, especially for small funds. Before buying an ETF that is not well known, you should check to see how big the expense ratio can be.
Expense ratios can vary from 0.05% to 1.5%, with most below 0.35%. That is a percentage of the total holdings of the fund, deducted on an annual basis.
ETF rotation strategies are a popular way to use a group of ETFs. Money can either be moved into the ETF with the highest momentum or from ETFs that have performed well to those that have underperformed. That’s exactly what Logical-Invest helps you to do.
ETF investing is a cost-effective, easy way to get invested in the market and learn about investing.