What Is an ETF and How Does It Work?

Sep 10, 2021 05:07 PM ET
What Is an ETF and How Does It Work?

ETFs are exchange-traded funds. These are pools of goods and services that have characteristics similar to that of a stock. There are many types of ETFs that are made up of different components; stocks, bonds, and securities, which are essential for diversification and hence risk management. 

The two main types of ETFs are a stock index like the S&P 500 or a sector ETF which tracks the index of companies from a particular sector. The former offers more diversification. Therefore, it is usually the more popular option. 

According to financial experts, ETFs are the safest way to get into investing. As a result of its diversified structure, the capital investment will be spread across components of the ETF, reducing the risk of an individual component failing. This is also an investment method recommended by billionaire investor Warren Buffet. 

Investors receive gains through two different methods: capital gains and dividends. Depending on individual ETFs, dividends can be distributed as fiat or reinvestment into owning more shares. This allows investors to benefit from the effect of compound interest. 

As ETFs follow a market index, it has very low risk. For an ETF to fail, the whole market will need to fail. In the long term, generally, all markets develop. The safe nature and benefits of compound interest make ETFs an attractive form of long-term investment. 

Advantages

Saving research time

Investing in an ETF is more time-efficient than individual stocks. Investors do not have to track different stocks and form an analysis of their strategies, performance, or future potential. An ETF will filter out securities that are performing poorly. With an ETF, the cream will rise to the top. 

Low entry price

ETFs do not have a minimum entry price. Investors can get started by just having enough capital to buy one share of an ETF of their choosing. 

ETFs also have lower fees due to a low requirement of management fees and service fees for marketing and advertisements. 

Diversification

An ETF follows a market index. For example, the S&P 500 follows the top five hundred companies in America, ranging from Apple to Paypal and Netflix. These are companies from different industries and, therefore, will create diversification and reduce risks. If the smartphone industry collapses, the risk is spread and can be covered by companies from other industries. 

There are also ETFs for different sectors. These are aimed at people who believe in a certain sector but want to be involved in a safer investment. Compared to other ETFs, sector-based ETFs are less diverse. 

Characteristics of a stock

An ETF shares many characteristics with a stock. 

  1. It can be traded on margin, and investors can obtain different positions.

  2. It can be traded throughout the day because prices fluctuate, unlike a mutual fund which only updates its price at the end of the day. 

  3. Investors can future trade ETFs and benefit from speculatory trades. 

Disadvantages

High-risk mutual fund

Compared to a mutual fund, an ETF has a relatively high risk due to its stock-like characteristics. The ability to trade throughout the day with market fluctuations leaves investors vulnerable to emotionally-driven trades. 

Low returns

The trade-off of having lower risks than stock is a lower return. As investment funds into an ETF are spread across different assets, the potential for capital growth is significantly lower than an individual stock. 

Furthermore, if a stock yields dividends, it will also be higher than dividends from an ETF. 

Low liquidity

Despite the ability to trade, ETFs are not traded regularly. This stems from the fact that many view ETFs as long-term investments. 

As a result, at times, liquidity can be low, which makes it difficult and risky when an investor wants to exit. 

Considerations when choosing an ETF

Liquidity

Liquidity is the volume that circulates the market. It is extremely important when it comes to an exit strategy. High liquidity allows your orders to be filled faster and a lower chance that your investment will be ‘stuck’ in the market. 

Low caps ETFs usually have low liquidity, which makes it more difficult to exit. Therefore, there should be careful considerations of risks and rewards with low caps ETFs.

Tracking accuracy

Most ETFs track a certain index in the market. However, some are not tracked as closely or accurately as they should. Because of this, investors could be disadvantaged and lose out on the possible profits that come from a change in the price. 

This could also be an indication of the quality and trustworthiness of the ETF, which is also an important consideration when choosing which to invest in. 

Levels of assets

The main selling point of an ETF is its high level of diversification. Some ETFs (especially sector-based) might not be diverse enough for investors to benefit fully. This will lead to low consumer interest, which is reflected through the low trading volumes. 

Low trading volumes also mean low liquidity, which might cause problems when an investor decides to exit. 

Underlying index

The underlying index that the ETF tracks should also be considered. Many experts suggest a general index to increase diversification instead of a niche index that is the sector or geographically focused. 

However, investors should choose an index that they are knowledgeable about and are confident that it will result in profitable yields. 

Conclusion

An ETF can be seen as a middle-ground between a mutual fund and a stock. The advantages of an ETF show that it is a safer equivalent of stock. It could also be a higher risk than a mutual fund. 

Although recommended by many, and is on paper, one of the safest ways to invest, investors still need to do research and find out the optimal ETF for their own goals and strategies. 

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