An exchange-traded fund, or ETF, is a collection of several stocks or bonds in a single fund. It also refers to a collection of securities you trade on a stock exchange through the aid of a brokerage firm. ETFs are applicable to most asset classes, including traditional investments & alternative assets such as commodities or currencies.
Exchange-traded funds are one of the greatest things that has ever happened to investors because they help the investors in gaining leverage and avoiding short-term capital gains taxes in a very easy way.
Exchange-traded funds are some of the renown new securities that was introduced right after the mutual fund.
Just like a stock, ETFs are readily available for trading (buying and selling) whenever the stock exchanges are open, and they also comes with ticker symbol and intraday price data that can be easily accessed during the trading hour.
Whenever an investor purchases an ETF, he or she is basically investing in the performance of an underlying bundle of securities -- usually those representing a particular index or sector. Unit Investment Trusts (UITs) are often organized in the same manner. However, the unusual legal structure of an ETF makes the product somewhat unique.
Exchange-traded funds don't sell shares directly to investors. Instead, each ETF's sponsor issues large blocks (often of 50,000 shares or more) that are known as creation units. These units are then bought by an "authorized participant" -- typically a market maker, specialist or institutional investor -- which obtains shares of the underlying securities and places them in a trust. The authorized participant then splits up these creation units into ETF shares -- each of which represents a legal claim to a tiny fraction of the assets in the creation unit -- and then sells them on a secondary market.
Here are some of the most common types of ETF:
Long ETFs. These take a “long position” on their underlying indexes. They typically own shares of companies in a specific index. If the index rises, so do share prices in long ETFs, by about the same amount, minus any expenses and trading costs.
Inverse ETFs. The opposite of long ETFs. They take “short positions” on the underlying index. Share prices move in the opposite direction to ETF shares. If the index loses money, you win.
Gold ETFs. These ETFs invest in a representative sample of gold stocks, or they hold claims on actual gold bullion, held in trust by a custodian. Shares in gold ETFs typically move in rough tandem with gold prices. You can also buy ETFs that focus on precious metals more generally.
Industry ETFs. These ETFs own a portfolio of stocks representing an industry, such as energy and oil, technology, mining, transportation, health care, and so on.
Country ETFs. These investments buy shares in companies that represent a cross-section of industry in a given country. For instance, they may own shares of the largest 50 publicly traded stocks in a specific country as measured by market capitalization. You can also buy regional ETFs as well, which focus on entire continents.
Leveraged ETFs. These funds use borrowed money to “gear up” their portfolios, magnifying returns. They also magnify risks as well. For instance, a leveraged S&P 500 ETF will seek to roughly double the returns of the index, minus interest and expenses. But they will also double the size of losses as well. You can also buy leveraged inverse ETFs – these are very risky.
Currency ETFs. These securities seek to capture the returns of foreign currencies.
Bond ETFs. These are just like stock ETFs, except they own bonds instead of stocks.
There are numerous advantages to ETFs, especially when compared to their mutual fund cousins. They include:
Tax-Friendly Investing—Unlike mutual funds, ETFs are very tax-efficient. Mutual funds typically have capital gain payouts at year-end, due to redemptions throughout the year; ETFs minimize capital gains by doing like-kind exchanges of stock, thus shielding the fund from any need to sell stocks to meet redemptions. Therefore, it is not treated as a taxable event.
No Investment Minimums—Several mutual funds have minimum investment requirements of $2,500, $3,000 or even $5,000. ETFs, on the other hand, can be purchased for as little as one share.
Lower Cost Alternative—The average mutual fund still has an internal cost well over 1%, whereas most ETFs will have an internal expense ratio typically between 0.30-0.95%. Plus, ETFs do not charge 12b-1 fees (advertising fees) or sales charges, as do many mutual funds.
More Trading Control—Mutual funds are traded once per day at the closing NAV price. ETFs trade on an exchange all throughout the trading day, just like a stock. This allows you greater purchasing/selling price control and the ability to set protection features, such as stop-loss limits on your investments.
Transparency— This is a great benefit because you know what you own at all times. That is to say, you always know the underlying securities in an exchange traded fund. In contrast, mutual funds report their holdings once a quarter. This advantage may not be critical to many investors of index funds, but it can be an important consideration for those considering an actively managed mutual fund.
Trading flexibility — Traditional open-end mutual fund shares are traded only once per day after the markets close. All trading is done with the mutual fund company that issues the shares. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid for new shares when buying that day and the price they will receive for shares they sold that day. Once-per-day trading is fine for most long-term investors, but some people require greater flexibility.
ETFs are best suited for investors who intend to hold them for a long time. This gives the lower long-term expense ratios of these securities (compared to competing actively managed mutual funds and even open-end index funds) time to build up. They are also very useful as trading vehicles, especially if you don’t want to drill-down too deeply in any one company, or retain too much individual company risk.
The most important consideration, from a suitability point of view, is the underlying index and how it fits in with your overall portfolio and strategy.
