ETF (Exchange-traded fund) : The definition

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ETF

The ETF or the exchange-traded fund is something that can be traded on a stock exchange, just like stocks or equities. They are known to have lower fees as compared to different funds. The risk involved with an ETF varies as the underlying asset changes. This does not mean that the traders should go ahead and trust them blindly. Like any other financial asset, ETFs must be read on all levels, and their merits and demerits should be correctly evaluated.

How do ETFs work?

This is how an ETF works:

The fund provider owns the underlying assets. The provider also designs a fund to track the performance, and later, the shares of that fund are sold to the investors. The shareholders own a portion of the ETF, but they don’t own the complete underlying asset of the fund. Apart from that, the investors can get some payments in the form of lump dividends or reinvestments for the stocks that the index is made up of. 

One interesting fact about ETFs is that they are traded on the exchange at a price that is not the price of the underlying asset that they track. The asset inside the fund might be gold, but the prices of gold on the exchange might differ from the fund. Apart from that, the Longer-term outcomes of the ETF may differ from that of the underlying asset.

Here is a simple overview of how the ETFs work:

  1. An ETF provider takes under consideration a whole universe of assets that include commodities, currencies, stocks, bonds etc. and creates a “basket” from them. This basket has a unique ticker symbol. 
  2. The investor can buy a share from that basket just like they would buy the shares of that firm. 
  3. The sellers and buyers trade the exchange-traded fund from the stock exchange throughout the day just like a stock.

Mutual funds vs ETFs: a quick comparison. 

To put it into consideration, ETFs have a lower fee as compared to Mutual funds. This is a big part of that complete appeal. As of 2019, the average admin expense calculated annually for equity mutual funds was around .50%. The same for the ETF expense was .18%. 

ETFs are also known to provide advantages to investors in terms of tax efficiency. There is a better turnover with mutual funds, specifically the ones that are managed actively. When it comes to the ETFs, their selling and buying may or may not generate capital gains.

When a seller wants to sell a mutual fund, the manager of that fund will have to sell some securities in order to raise cash. Here, the taxes will be in a loop, and the seller will have to cut short in the gain because of the tax expenditure. 

ETFs are becoming popular day by day, but the number of mutual funds available in the market is still considerably high. Both the products have a different structure in terms of management. 

Stocks vs ETFs:

Just like stocks, the ETFs can be easily traded on an exchange with a ticker symbol That allows the traders to trade actively. A major difference between stocks and ETFs is that the stocks represent the shares of one company while the ETFs represent a whole basket of stocks. Since ETFs have the capability to include multiple assets, They can provide a better portfolio diversification than one single stock. Diversification helps the portfolio in mitigating the risk exposure of the portfolio. 

There are times when the ETFs are focused on certain sectors. For instance, SPY is one of the ETFs that track the S&P 50 index, and there are also ETFs like HACK for a cybersecurity fund, and FONE is an ETF that is focused on the smartphone specific market. 

Pros and cons of ETFs:

As of 2020, more than $500 billion was inflowed in the ETF listed in the US alone. This number is more than 50% up to as compared to the ETF inflow as of 2019. The investors are attracted towards the cheapness, simplicity and access to the diversified product. 

Pros of ETF investments:

Diversification:  

When people think of diversification, it is easy to think in terms of verticals. Like bonds or a particular commodity, but when it comes to the horizontals like diversifying in terms of different industries altogether, the ETFs come in handy. If an investor wants to buy stocks of different industries as well, ETFs can do that for them.

Understand it this way: The mutual fund can be of one sector of stocks. There can be multiple stocks of the SAME sector. Google, Amazon, Microsoft etc. fall into the same sector.  

The ETFs, on the other hand, can be of different industries, and the investors can enjoy better diversifications. 

Transparency: 

Anyone who has internet access can search the price activity or a specific ETF that happens over an exchange. Apart from that, the holdings of the funds are announced to the public each day. If taken in contrast with the mutual funds, it happens only on a quarterly or monthly basis. 

Tax benefits: 

The investors are mostly taxed when the investment is settled. When it comes to Mutual funds, they take such burdens throughout the course of the investments. 

Cons of ETF investment:

Trading costs: 

The trading costs might not end up with the ratio of expense. Since the ETFs are traded on exchanges, they can be subject to the commission fee from the brokers online. A lot of brokers don’t charge for that, but a lot of them still do. 

Liquidity issues possibilities:  

Just like any other security, the trader is always at the mercy of the current market situation when the time to sell comes, but the ETFs that are less frequently traded can be harder to dump. 

The risk that the ETF will shut down: 

The major reason as to why that would happen is that the fund has not brought enough assets to balance the admin costs. The biggest drawback of a shutdown ETF is that the sellers have to sell way before then they intended to. This almost always comes with a loss. There is also the probability, and it is an annoying probability, that the trader has to reinvest the money, and with that comes the burden of taxable money that naturally comes from the profits earned. 

Which ETFs are correct for your portfolio?

The investors need to remember that the trading cost of most of the ETFs is low, but still, they can vary from fund to fund. This depends on the person who issues the funds and the demand and complexity of the fund. 

Most of the ETFs are investments that are managed passively, and they almost always track an index. Some investors prefer mutual funds because the approach there is more hands-on experience-based. These funds are run by professionals and managers whose jobs are mostly around how to outperform the market. It is crucial that the investors look at their style of investments before they begin buying. 

Since the market has exploded, it has seen some of the funds that come in but do not perform the way they were expected to perform. To put it in simple terms, if the ETF is cheaper, then it is not necessary that it performs well over your trading expectations. 

ETFs: how to invest?

There are a lot of ways with which traders can invest in ETFs. How you do it mostly comes from the fact that what is the preference. For investors that trade hands-on, investing in ETFs is always just a click away. Almost all online brokers provide ETFs as standard assets.

The fee may vary with the broker. The market of Robo advisors is also on the rise. WHat these AI-based advisors do is that they make their suggestions on the basis of how low the trading cost is and how things work around with the ETF shoppers. 

The traders need to understand the ETFs have complexities that they have to understand before getting financially involved with the funds in whatsoever manner. After they learn what the whole idea is, they can later embark on the exciting new journey of the market and its volatility. 

The best ETFs out there:

They may trade like stocks but, the ETFs have a lot of resemblance to mutual funds and also index funds. Although, there is still a great possibility that they might differ on the basis of the underlying asset and the investment goals of the trader.

Below are some of the best ETFs. It has to be kept in mind that these categories are not mutually exclusive. For instance, an ETF can either be based on an index and also, vice versa. These ETFs are not generalised on the basis of the type of management but on the basis of the investments held with the ETF. 

Stock ETFs:

They are made up of stocks that are meant for growth in the long term. They are less risky than the individual stocks, but they also walk in with a subtly increased risk than the others, like the Bond ETFs. 

Commodity ETFs:

Commodities are nothing but the raw goods that the average American uses in his or her daily life. The most prominent examples are coffee, gold or even crude oil. The Commodity ETF allows the investors to pack all the investments in a single investment. 

With the commodity ETFs, it is crucial that the trader knows what is inside them. Is the ownership in the physical funds, or is there personal equity in the firms that produce and/or transport such goods? Is the ETF holding a futures contract within itself? Does the commodity come under the collectable for the IRS? All these factors come with varying levels of tax implications and also varying risks. 

Conclusion: 

The traders can trade on ETFs over the best online broker FXTm or the goliath broker XM. Both of these barkers are legitimate and also come in with various regulations at par with the IRS. 

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