How does an ETF work?
An ETF typically works as a basket of pooled securities in one asset class (e.g. a basket of equities or a basket of bonds). As an investor, you can buy shares in the ETF and own a share in the pooled assets as well as their dividends.
Imagine a hamper basket filled with a variation of different securities (such as a basket of stocks, or large number of bonds, or different commodities (e.g. gold) or even a mixture of different securities) with an asset manager in charge of buying, selling, and rebalancing the contents for you. The trading ground/market is the stock exchange, and you, as an investor in this basket of assets, can buy and sell the components of the basket at any time. Welcome to your Exchange Traded Fund (ETF)!
The model ETF investor is sick of trading commissions and wants to have a broad asset base and diversify without going through the back-breaking work of building these assets individually. What makes the ETF such a good fit for this investor is the combination of the major benefits of mutual funds and stocks: portfolio diversification (similar to what a mutual fund provides) and liquidity (which stocks provide).
Many ETFs work by tracking indices, for example the S&P500 (a stock index) or Barclays Capital U.S. Government Bond Index (a bond index), and buying or selling assets to keep along with the index components.
As an investor, you don’t get to buy/sell the components of an ETF basket directly; they are only bought from or sold to authorized participants (e.g. a large broker-dealer). These authorized participants act as market makers on the open market, utilizing their ability to exchange units of the ETF with the underlying securities to provide liquidity. This makes sure that the market prices of the ETF are very close to the net asset value of underlying assets. In this way other investors can trade ETF shares on the secondary market.
ETFs could either be leveraged or non-leveraged. Leveraged ETFs often experience value decay over time because of daily rebalancing and are noted to be riskier and more volatile to invest in. This article focuses mainly on non-leveraged ETFs, which make up the significant majority of offerings.
These days, ETFs offer a vast range of different asset types, indexes, and trading strategies while keeping minimal fees. You can invest in anything from oil to treasury bonds to the yen to everyday stocks using ETFs.
Are ETFs a good investment?
Yes, ETFs are a good investment because of their diversification, high liquidity, lower transaction costs, and high tax efficiency.
ETFs provide you with low-cost access to investment in a variety of assets such as commodities, bonds, equities, real estate etc. This diversification of assets is a solid advantage that every smart investor craves.
There is also no restriction on trading ETFs. ETFs can be sold/bought at any time during trading hours (unlike mutual funds) and considered very liquid. This means you don’t have to hold on to an ETF for any longer than you want to. In fact, some traders will buy and sell ETFs multiple times in a single day to take advantage of swings in market prices.
With an ETF, transaction and management costs are often much lower than when you trade individual stocks. This is well exemplified by the fact that over $2 trillion US dollars have been invested in ETFs between their inception in 1993 and 2015. Many brokers offer free or discounted trading for ETFs as well. Some ETFs even claim they have a 0% management fee!
The high tax-efficiency of ETFs combined with stock-like features make them very attractive to have as investments. You can find out more about an ETF’s tax efficiency in our next section.
Which is better: an ETF or a mutual fund?
There are three major factors which combine to make the ETF a better investment than a mutual fund. They are: liquidity, tax efficiency, and expense ratios.
The liquidity of ETFs is highly varied; however active/popular funds (such as SPY and QQQ, two ETFs that track the S&P500 and Nasdaq-100 respectively) are very liquid. Because of the high liquidity of these funds, they tend to be associated with high volumes and constant price changes during the day. This is very different from mutual funds where all trades happen at a single price at a single time after market close.
The genius model that guides the structuring of ETFs ensures tax efficiency. This makes them more attractive as investment opportunities than mutual funds.
To understand this better, let us compare the effects of capital gain realization by an ETF or a mutual fund. When capital gains are realized by a mutual fund- e.g. when portfolio securities are sold (and this isn’t balanced by a loss), the mutual fund has to share the capital gain amongst its shareholders. Shareholder redemptions from such capital gains are taxable for mutual funds even when the gains are reinvested in more mutual fund shares!
ETFs are better optimized to evade these taxes, as when gains are made, there isn’t a need for this sort of redemption by shareholders. Instead, these shareholders can sell their ETF shares on the stock market for gains, or alternatively, make non-taxable in-kind redemptions by which shares are redeemed for a basket of securities held by the ETF.
For this reason, ETFs are more tax-efficient when compared to mutual funds in the same categories or asset classes.
ETFs have lower expense ratios
Annual administrative expenses (the percentage of the fund’s total assets estimated to cover its operating expenses per year), otherwise known as expense ratios are typically lower for ETFs in comparison to mutual funds. With higher expense ratios for mutual funds, investors get lower total returns. While the average equity mutual fund in the U.S has an expense ratio of 1.42%, a comparable equity ETF has an expense ratio that’s only 0.53%, leading to higher returns for investors in ETFs, when compared to mutual funds.
Do ETFs pay dividends?
Yes, some ETFs are known to pay attractive dividends, especially when comprised of stocks/bonds.
The fund provider will collect the dividends issued from the assets of the ETF and then often redistribute them at regular intervals to the holders of the ETF. There are ETFs dedicated to tracking high-dividend stocks or bonds that can often be a good idea for income investors. Investors who receive their dividends can choose to either buy more shares of the ETF or allocate it for other uses.
Are ETFs safer than stocks?
The answer for non-leveraged ETFs that are a basket of stocks or bonds is yes. Since ETFs are typically portfolios of many stocks or bonds, they tend to be highly diversified and much safer than an individual stock or bond. It is recommended that beginners invest in ETFs to avoid big financial stress. Notwithstanding, there’s a caveat. There are ETFs track volatile or risky indexes (e.g. Commodity ETFs, Blockchain ETFs, Currency ETFs) where you can experience the same or greater risk as investing in a typical stock. You should always make sure to be aware of what you’re investing in and know your own personal risk tolerance.
When high volatility is mentioned, leveraged ETFs come to mind since like any leveraged investment such as real estate, you are (indirectly) playing with borrowed money. Also leveraged ETFs are associated with high investment risks due to daily resets which results in a value decay over time. However, there are also ETFs dedicated to tracking investments with low volatility, such as the iShares Edge MSCI Min Vol USA ETF. These kinds of ETFs are considered smart investments owing to the fact that they are more stable - they perform better than most niche ETFs in bear markets, but aren’t the best performers in bull markets either. However, these might be a good tool for risk averse investors to get exposure to stocks.
ETFs: To Invest in them or not? Yes, you should invest in ETFs for the following benefits:
- ETFs give you the exciting option of investing in a vast variety of asset classes - including bonds, stocks, commodities or currencies.
- As an investor, you engage in portfolio diversification when you buy shares in that basket (i.e. shares in different companies) which means lower risk.
- Liquidity. You can buy and sell your shares of the ETF during market hours whenever you want.
- ETFs have higher liquidity, greater tax efficiency and lower expense ratios when compared to mutual funds, and as such, are better investments than mutual funds.
- Attractiveness of dividends - and the option of reinvesting for better gains is always open.