Exchange-Traded Funds (ETFs)
Like a mutual fund, an exchange-traded fund (ETF) functions as a pooled investment security. ETFs usually mimic an index, sector, commodity, or other group of assets’ performance. Unlike mutual funds, however, Exchange-traded funds (ETFs) can be bought or sold on a Stock exchange just like regular equities.
From the value of a single commodity to a diverse group of Stocks, ETFs can be created to track a wide range of assets. ETFs may also be created to adhere to specific investment philosophies. The SPDR S&P 500 ETF (SPY) was the first ETF created that tracked the S&P 500 Index and is still frequently traded today.
History of Exchange-Traded Funds (ETFs)
The history of ETFs began in 1989 with the introduction of Index Participation Shares (IPS), which faced legal challenges due to their resemblance to futures contracts. In 1990, Toronto Index Participation Shares started trading, prompting the American Stock Exchange to seek a compliant solution. In 1993, Standard & Poor’s Depositary Receipts (SPDRs or “Spiders”) emerged as the largest ETF, tracking the S&P500.
Since 1995, ETFs have gained popularity, experiencing annual asset growth and receiving support from Vanguard. Barclays launched iShares MSCI Index Fund Shares in 1996, providing access to foreign markets. In 1998, “SectorSpiders,” “Dow Diamonds,” and “cubes” replicating the NASDAQ-100’s price movement were introduced. iShares gained a significant market share in 2000 and was acquired by BlackRock in 2009. Vanguard entered the ETF market in 2001, followed by the introduction of bond funds by iShares, State Street Global Advisors, and Vanguard in 2002. In 2005, Rydex (now Invesco) pioneered currency ETFs, and ProShares issued the first leveraged ETF in 2006. The SEC authorized actively managed ETFs in 2008, with Bear Stearns launching the first one. U.S. ETFs reached milestones of $2 trillion in 2014, $4 trillion in 2019, and $5.5 trillion in 2021.
The Central Fund of Canada, established in 1961, played a key role in gold ETF history. It provided ownership of gold and silver bullion through its closed-end fund, listed on the Toronto Stock Exchange since 1966 and the American Stock Exchange since 1986. The first gold ETF, Gold Bullion Securities, was launched on the ASX in 2003. The iShares Silver Trust, the first silver ETF, followed in 2006 on the NYSE. SPDR Gold Shares is a popular commodity ETF and ranks among the top 10 in terms of assets managed.
ETFs have a unique approach to selling and redeeming shares. Financial institutions directly purchase or redeem ETF shares in large creation units that mirror the ETF’s portfolio. This minimizes deviations between market price and net asset value. ETFs offer transparency through the real-time dissemination of net asset value and disclosure of portfolio composition. Authorized participants, large broker-dealers, exclusively trade with ETF distributors, acting as market makers to ensure the market price reflects net asset value. Strong demand may cause temporary price premiums, allowing arbitrageurs to buy creation units and sell ETF shares. This maintains close tracking of net asset value.
How Does It Work?
ETFs, or Exchange-traded funds, are traded on marketplaces similar to Stock exchanges. Their prices fluctuate during the trading day as they are bought and sold. Compared to mutual funds, which only trade once per day after the markets close, ETFs offer more cost effectiveness and liquidity. ETFs provide diversity by holding a variety of underlying assets. Stocks, commodities, bonds, or a combination of investments can be included. ETFs might be narrowly focused on a few industries or sectors, or they can be very broad, owning hundreds or thousands of equities across industries. While some ETFs are US-centric, others are worldwide in scope. ETFs have share prices and can be quickly purchased, sold, or shorted on exchanges since they are marketable securities. The majority of ETFs in the United States are open-ended funds that must comply with regulations.
Types of ETFs
Investors can choose from a variety of Exchange-traded funds (ETFs). Here are a few of the most typical:
Sector/Industry ETFs
Industry/Sector ETFs are investments that focus on particular sectors or industries, like technology or energy. They give investors access to information about the operating results of businesses operating in certain industries. Since they don’t require direct ownership of any Stocks, ETFs have the benefit of reducing the downside risk associated with erratic Stock performance. Additionally, during various economic cycles, sector rotation tactics are applied using industry ETFs.
Passive and Active ETFs
ETFs can be divided into passive and actively managed categories. Whether it’s a broad index like the S&P 500 or a focused sector or trend, passive ETFs seek to mirror the performance of a certain index. For instance, a number of ETFs are concentrated on the equities of gold mining companies. On the other hand, actively managed ETFs have portfolio managers who choose which assets to put in the fund’s portfolio. While actively managed ETFs have some benefits, investors often find them to be more expensive than passive ETFs.
Stock ETFs
Similar to an index, these ETFs carry a portfolio of stocks, or equities. They can be bought and sold on an exchange at any time during the trading day, just like regular Stocks.
Index ETFs
These ETFs seek to replicate an index’s performance, such as the S&P 500. They may concentrate on particular industries, Stock types, or even international or developing markets.
Bond ETFs
These ETFs hold bonds and other fixed-income instruments as investments. They could focus on a specific kind of bond or provide a diverse portfolio of bonds with various maturities.
Commodity ETFs
Physical commodities like agricultural products, raw materials, or precious metals are held by commodity ETFs. Some people might mix equity investments in connected industries with physical commodity investments.
Currency ETFs
Currency Exchange-traded funds (ETFs) can invest in a single currency or a basket of currencies. Without directly trading futures or the forex market, they give investors access to the foreign exchange market.
Inverse ETFs
The goal of inverse ETFs is to make money when the value of a basket of assets or a broad market index declines. To accomplish this inverse relationship, they use derivatives.
Leveraged ETFs
Financial derivatives are used by leveraged ETFs to boost investment returns. They are frequently used by investors who want to take advantage of short-term tradingopportunities in significant Stock indices.
Real Estate ETFss
Real estate Exchange-traded funds (ETFs) invest in mortgage-backed securities (MBS), real estate investment trusts (REITs), real estate service companies, and sometimes even actual real estate properties.
Key Considerations for Investing in ETFs
It’s important to keep a few things in mind when investing in ETFs. The following are important things to keep in mind:
Differentiate ETFs from Stocks
Despite the fact that ETFs can be traded on Stock exchanges like Stocks, it’s critical to understand their differences. Since ETFs more closely resemble mutual funds, it is advised to approach them from a long-term investment perspective rather than frequently engaging in intraday trading.
Market Performance Expectations
ETFs are made to closely follow particular benchmark indices. As a result, they are not meant to outperform the market as a whole. During market downturns, ETF returns might be subpar. It’s critical to keep expectations in check and understand that ETFs aren’t designed to outperform the market.
Evaluate ETF Age
Before making an investment decision, take the ETF’s age into consideration. Older ETFs frequently have a wealth of historical data available, allowing you to evaluate their performance. But keep in mind that past success does not ensure future success.
Assess Tracking Error
Ideal tracking accuracy is modest or almost zero. If an ETF’s performance drastically differs from its benchmark index, it may not be accurately replicating the investments of the index. When considering an ETF, consider the tracking inaccuracy with great care.
Examine Liquidity
Make sure the ETF you choose has enough liquidity, as evidenced by the exchange’s trading volumes. It is simpler to buy and sell ETF shares when there is greater liquidity since lower bid-ask spreads result. A critical consideration before investing in any ETF is liquidity.
Examples of Popular ETFs
Here are a few current examples of well-known ETFs. While some ETFs specialize in certain sectors, others follow Stock indices to create broader portfolios.
| ETF Name | Ticker Symbol | Index Tracked |
|---|---|---|
| SPDR S&P 500 | SPY | S&P 500 Index |
| iShares Russell 2000 | IWM | Russell 2000 small-cap index |
| Invesco QQQ | QQQ | Nasdaq 100 Index |
| SPDR Dow Jones Industrial Average | DIA | Dow Jones Industrial Average (30 Stocks) |
| Sector ETFs | – | Various sectors (e.g., oil, energy, etc.) |
| Commodity ETFs | – | Commodity markets (e.g., gold, silver, etc.) |
| Country ETFs | – | Foreign Stock indexes (e.g., China, Brazil, etc.) |
| Emerging Market ETFs | EEM | Broad range of emerging market economies |
| Developed Market ETFs | EFA | Broad range of developed market economies |
Investing in ETFs
Choose the Investing Strategy You Desire
Depending on your preferences, there are several ways to invest in Exchange-traded funds (ETFs). Online brokers provide a wide selection of ETF options for active investors. On the other hand, robo-advisors build portfolios using inexpensive ETFs to appeal to more passive investors. Today, a large number of reputable brokerages provide commission-free transactions in Stocks, ETFs, and options.
Open a Brokerage Account
Before you can start investing independently in ETFs, you must open a brokerage account. You use a brokerage account to make your investments. You must choose and fund the account using ETFs; simply opening an account does not mean you are automatically invested in anything.
Identify the Desired ETFs
Even if there are many ETFs available, employing online screeners might make it easier to find the best ones. These tools can assist you in finding ETFs that are focused on socially conscious or environmentally friendly investments, have minimal expenses, have a particular sector exposure, or all of the above.
Purchase the Chosen ETFs
Find the precise ETF you wish to buy using the trading feature of your brokerage, then place the trade. Just before completing the purchase, review your order.
Hold onto Your ETFs
You might hold onto an ETF for a very long time, depending on your investment strategy. For long-term retirement planning, holding onto your ETFs for a long time is typically advantageous. Compounding interest works in your favor the longer you hold your investments. A longer investment horizon also enables you to navigate market swings and profit from long-term positive Stock market trends.
Comparison of Features: ETFs, Mutual Funds, Stocks, and Index Funds
| Features | ETFs | Mutual funds | Stocks | Index Funds |
|---|---|---|---|---|
| TradingHours | During trading hours, exchanges are possible at any time. | Only bought or sold at the start or end of a trading day. | During the regular market hours. | Only bought or sold at the start or end of a trading day. |
| Tax Efficiency | More tax-efficient as money comes directly to your account upon sale. | Redemption of index funds incurs capital tax. | Either subject to capital gains tax rates or regular income tax rates. | Capital tax is due when index funds are redeemed. |
| Ownership | Do not involve actual ownership of securities. | Own the securities in their basket. | Involve physical ownership of the security. | Own the securities in their basket. |
| Diversification | Track various businesses within an industry or sector using a single fund. | Make a portfolio that includes a variety of asset classes and investment types. | Stock performance is where risk is focused. | Follow a portfolio of securities. |
| Pricing | Trades that have a loss or profit potential compared to the net asset value (NAV). | Trades at the fund’s overall net asset value. | Returns determined by how well they actually performed in the markets. | Trades at the total fund’s net asset value. |
| TradingMethod | In-kind distributions, cannot be redeemed for cash. | Shares can be redeemed for money at NAV. | Bought and sold using cash. | Shares can be redeemed for money at NAV. |
| Fees | Some can be purchased commission-free, generally have lower fees. | Some do not charge load fees, but often more expensive due to administrative and marketing fees. | Can be purchased commission-free on some platforms, minimal charges after purchase. | Some can be purchased commission-free, fees vary. |
ETF Creation and Redemption Mechanism
- Authorized Participants (APs) and specialist investors are involved in the creation and redemption of ETFs.
- ETF Creation: AP purchases index equities and trades them for fresh ETF shares with the ETF.
- When ETF shares trade for more than the fund’s net asset value (NAV), creation takes place.
- To align the share price of the ETF with the NAV, AP purchases Stocks from the market.
- A larger ETF share base lowers the price and brings it into line with the fund’s NAV.
- ETF Redemption: AP purchases market-traded ETF shares and then returns them to the ETF provider.
- Redemption occurs when ETF shares trade at a discount to the fund’s NAV.
- AP purchases ETF shares and trades them for shares in the portfolio of the underlying stocks.
- Redemption reduces the number of ETF shares available, pushing the price up towards the NAV.
Unique Features of ETFs
Passive Management
Since the specified asset basket does not change unless the components of the underlying index change, ETFs function without the need for a fund manager. For instance, holding the top 50 equities in the portfolio, which comprise the Nifty index, entails investing in the Nippon India ETF Nifty BeES. Only when the Nifty composition changes and ETF returns coincide with Nifty returns do adjustments take place.
Tracking Precision
Based on its tracking error, which quantifies the difference between the returns of the ETF and its benchmark, an ETF’s performance is assessed. Regardless of whether the tracking error is positive or negative, when it becomes close to zero, it shows a good correlation between the ETF and the index. While the converse is true, persistently positive tracking errors indicate increased efficiency.
Cost-Effectiveness
ETFs have low monitoring requirements, which makes them cost-effective. Since there is no active fund management, there are no costs related to Stock selection, and transaction costs are minimal. Similar to Stock shares, brokerage fees will be charged to investors when they buy or sell ETF shares.
High Liquidity
ETFs allow investors to conveniently acquire or sell shares because they trade on Stock exchanges. The possibility to profit from market volatility during trading hours, which is not feasible with mutual funds, is advantageous to investors. Additionally, whereas ETFs do not charge exit costs when redeeming within a year, mutual fund investors frequently pay them.
Extensive Diversification
ETFs make investments in a variety of assets in amounts that roughly resemble those of the underlying index. By giving exposure to numerous top companies inside an index, this diversification reduces the risks associated with individual investments.
Simplicity
ETFs are primarily concerned with providing performance that is in line with indices like the Sensex, BSE 100, Nifty 100, and Nifty Next 50. For new investors, this makes the investment process simpler because they won’t have to worry about investment styles or evaluating prior performance in a variety of market environments.
Trading Price
Variance ETF unit prices may change in response to changes in the underlying securities’ net asset values (NAVs), which are impacted by market supply and demand. Investors should make sure that there is no major difference between the tradingprice and the NAV of the ETF.
Taxation
Since mutual funds and ETFs are both subject to the same tax laws, there are no appreciable tax distinctions between them.
Risks Associated with ETFs
- Tracking mistakes may occur when an ETF’s returns diverge from those of its reference index. A deviation from the benchmark might be caused by non-replication methods or illiquid underlying assets, among other things.
- ETFs have varying amounts of liquidity. When compared to more liquid ETFs, less popular ETFs may have low trading volumes, making them less liquid and possibly more difficult to sell.
- Regulations have been put in place as a result of market turmoil to guarantee that ETFs can handle systemic pressures. ETF pricing has, on occasion, become erratic, raising questions about regulatory compliance and increasing attention.
- Due to a lack of transparency, growing complexity, potential conflicts of interest, and problems with regulatory compliance, synthetic ETFs, which use futures and swaps rather than holding Stocks, may raise questions.
- Due to the counterparty’s contractual obligation to match the return of the index, synthetic ETFs are subject to counterparty risk. Risks can come from the quality of the collateral and from using the trading desk of the investment bank as a counterparty.
- Commodity purchases and sales by ETFs can have a substantial impact on their pricing, possibly causing price appreciation or raising questions about price manipulation.
- Despite tremendous development, there are still issues with perception and adoption in the European ETF sector. The effect on equity prices in developing nations and the possible use of ETFs for market manipulation are both causes for concern.
- Over time, the use of ETFs has grown, with higher uptake seen in conventional asset classes including equities and sectors. Investor satisfaction levels are high, particularly for the asset classes of government bonds and Stocks.
Pros and Cons of Exchange Traded Funds
| Pros | Cons |
|---|---|
| Access to Stocks across industriesLow expense ratios and fewer commissionsRisk management through diversificationETFs available for specific industry-focused investments | Higher fees for actively managed ETFsLimited diversification with single-industry ETFsLiquidity challenges affecting transactions |
In a Nutshell
- Due to their advantages over traditional mutual funds, including diversity, liquidity, and cheaper fees, ETFs have become quite popular among investors.
- ETFs provide ease by enabling investors to purchase and sell shares on Stock exchanges at any time of the day, giving portfolio managers flexibility.
- ETFs’ daily disclosure of their holdings, which enables investors to make well-informed investing decisions, is one of their main advantages in terms of transparency.
- ETFs appeal to investors who are cost-conscious since they have lower expense ratios than mutual funds.
- Despite the benefits, it’s crucial to be knowledgeable of the risks related to ETFs, such as possible changes in share values based on the underlying Stocks.
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Frequently Asked Questions
1.Are Dividends Distributed By ETFs?
ETFs can indeed pay dividends. The dividends earned on the shares of equities an ETF owns that pay dividends are paid to the ETF’s shareholders. As a result, an ETF will itself pay dividends to its owners if the equities it owns produce dividends.
2.Are ETFs Stocks?
Because it consists of a group of securities that replicate an underlying asset, market index, sector, or commodity, an ETF differs from a single Stock. These funds can, nevertheless, be bought or sold on Stock exchanges.
3.What Do ETFs Cost in Terms of Fees?
ETF prices can differ substantially. Popular ETFs have a median price of $59.42, with values ranging from $3.43 to $473.56. Options for all budgets are ensured by this broad price range. Setting your investment amount before joining the ETF market is crucial. Remember to take the expense ratio into account in addition to the price while researching ETFs. The cost incurred by the fund to run and manage it is represented by the expense ratio. Since most ETFs are passively managed, they often have lower expense ratios than other fund types.
