ETFs, or exchange-traded funds, are a popular investment
vehicle for investors that might want to gain exposure to a wide range of
assets, such as stocks, bonds, and commodities.
I want to talk a little bit about ETFs today and talk a little bit about
how they work, their advantages, and disadvantages. It is important to note that I am not a
financial planner or advisor, so the information in this post is intended to
educate and promote learning to make informed decisions with the guidance of
professionals. If you need financial
advice, please seek the advice of a financial professional in your area.
What are ETFs?
ETFs are investment funds that trade on stock exchanges. They can hold a variety of assets, including stocks, bonds, and commodities. They are designed to expose investors to a particular market or sector. ETFs are priced in real-time throughout the trading day, which means that investors can buy and sell ETFs at any time while the market is open. This is similar to trading individual stocks.
How do ETFs work?
ETFs are created and managed by financial institutions that are known as ETF sponsors. An ETF sponsor purchases a basket of assets that correspond to the ETFs investment objective. For example, if an ETF is designed to track the S&P 500 index, the sponsor will purchase all of the stocks in the index, in the same proportion that they are represented in the index. Once the basket of assets is assembled, the ETF sponsor will share the ETF and it is subsequently sold on the stock exchange. The market determines the price of the ETF, and it is based on supply and demand, which is just like individual stocks.
As investors buy and sell shares of the ETF, the sponsor can create or redeem shares to keep the price of the ETF in line with the value of the underlying assets. This is a process known as the creation and redemption mechanism. The purpose of this process is to keep the price of an ETF consistent with the value of the assets that it holds.
ETF Advantages
Low cost is a significant advantage of investing in ETFs. Since ETFs are designed to track an index or sector, they require less active management than traditional mutual funds. Lower management translates to lower fees and expenses, which has a positive impact on investment returns over the long term. Lower expenses mean a higher net return for the investor.
Diversification is another advantage of investing in ETFs. ETFs can hold a wide range of assets, which means that investors can gain exposure to a particular market or sector without having to purchase individual stocks or bonds. Diversification is important because it helps spread risk and reduce the impact of any one asset on the overall performance of the ETF or investor’s portfolio.
Finally, ETF trading is flexible. Since they are priced in real time throughout the trading day, investors can buy and sell shares of ETFs at any time the market is open. This is beneficial for investors that want to make quick trades or adjust their portfolio in response to current market conditions. This is similar to trading individual stocks, but with the added benefit of gaining access to a range of assets that make up the ETF.
ETF Disdvantages
Since ETFs are traded on stock exchanges, their prices are subject to market conditions that affect individual stocks. This means that there is a potential for volatility in the ETF price and value. There can be significant price fluctuations during volatile markets. As with any investment, there is always some risk that the investor takes on. Since this is a disadvantage of many investments, it is wise to seek counsel from a financial professional before committing any money towards investing in ETFs.
Previously, I mentioned that ETFs track a particular index or sector, but there is the potential for small differences between the ETF and underlying assets that it holds. This could be due to fees, expenses, and the mechanics of the creation and redemption process. To determine if an ETF is the best investment for you, review any fees that might be tied to the ETF and see if you can get a historical view to see how large that error might have been over the past few months. Please note that historical performance is not indicative of future performance, but reviewing and analyzing numbers in the past can help one understand how an ETF tracks against the underlying assets. For example, the SPDR S&P 500 ETF is one of the most popular ETFs that tracks the S&P 500 index. However, due to fees and other factors this ETF might not always perfectly track the performance of the index, such as in 2020 when the S&P index returned 16.25% and the ETF returned 16.05%.
Finally, some investors might be concerned about the lack of active management in ETFs. This means that investors would not be able to take advantage of market opportunities or avoid potential risks as effectively as they could with an actively managed fund. Of course, there is an offset here though, the fees for an actively managed fund will likely be higher than the ETF and that fee is likely to cover the management of the fund. A financial professional should be able to help you discern which is the best investment vehicle for you and your goals.
Types of ETFs
There are many ETFs available on the market and each has its own investment objective and strategy. Some of the more common ETFs include the following:
- Broad market ETFs, which are ETFs that track a broad market index, such as the S&P 500 or the Russell 2000. This provides investors with exposure to the overall stock market. Example ETF: SPDR S&P 500 ETF. Note this is just an example and not an endorsement for this ETF.
- Sector ETFs, which focus on specific sectors or markets, such as technology, housing, energy, healthcare, etc. These provide investors with exposure to companies within that sector. Example ETF: Financial Select Sector SPDR Fund. Note this is just an example and not an endorsement for this ETF.
- Bond ETFs invest in a variety of bonds. This includes government bonds, corporate bonds, or municipal bonds. This provides investors with exposure to the fixed income market. Example ETF: Vanguard Total Bond Market ETF. Note this is just an example and not an endorsement for this ETF.
- Commodity ETFs invest in commodities, such as agricultural products, gold, or oil. These provide investors with exposure to commodity markets. Example ETF: SPDR Gold Shares. Note this is just an example and not an endorsement for this ETF.
Final Thoughts, For Now
ETFs are a low-cost investment option that can provide a diversified exposure to a wide range of assets. They can be subject to volatile markets and are not actively managed, which can increase risk to investors as mentioned above. But the tracking of indexes or markets can allow investors to get exposure and experience with those indexes or markets at a relatively cheaper price than they would through active managed funds and can reduce the time spent on analyzing each and every individual stock, bond, or commodity. As with any investment, ETFs do carry risk and it would be very important for anyone to carefully consider their own investment objectives, goals, risk tolerance, and financial situation before investing in ETFs or any other security. As always with this site, we recommend seeking a financial professional in your area to help you determine which strategy is best for you. We just want to bring this information to you so that you can better understand various finance concepts and use that understanding in your conversations with your financial professional(s).
Disclaimer: I am not a financial advisor. The content on knowxchange.com or “this site” are for educational purposes only and merely cite my own personal opinions and experiences. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know and understand that all investments involve some form of risk. There is no guarantee that you will be successful in making, saving, or investing money. Additionally, there is no guarantee that you won’t experience any loss when investing. Please seek the advice of a financial professional and do your own research.