Exchange-traded funds (ETFs) have taken the investing markets by storm and are now one of the most important and valuable products for wealth creation in recent years. This meteoric rise in popularity is due the unique advantages and opportunities that ETFs give you, that other investment vehicles cannot match. According to the Investment Company Institute’s statistics, investors have paid in more than $3.5 trillion into ETFs since October 2018.
What is an ETF and why are they so popular? An exchange-traded fund (ETF) is a basket of different types of investments pooled into a single entity, which are then offered as shares to investors. These are then traded on major stock exchanges through a brokerage firm, and each ETF share gives it’s owner a proportional stake in the total assets of the exchange-traded fund.
The great advantage of this strategy is that anyone can invest in a wide variety of different assets for very little money. Most ETF shares cost $100 or less, but even one share can give you a fractional interest in dozens or even hundreds of companies.
By diversifying funds in this way, an investor can spread the risk over a wide variety of assets, avoiding the risk of serious losses if one company was to fail. Conversely, the investor would also only receive a fraction of the potential profit if that one company was to perform beyond expectations. ETFs give investors stability and security at very little cost.
Stock ETFs are by far the most common, with less than 20% going into bonds, commodities, and hybrid-style ETFs. Yet, funds still exist that target virtually every conceivable class of asset, from traditional to alternative investments, including hybrid ETFs that mix and match multiple types of assets. ETFs can contain many types of investments, including stocks, commodities, bonds, emerging markets, stock indices, growth over income or income over growth, foreign exchange or a mixture of investment types to suite your personal investment style.
Here are some examples of ETF types available:
- Actively Managed ETFs: These are actively managed in order to outperform an index, whilst most ETFs are designed to passively track an index.
- Alternative Investment ETFs: These are innovative structures, such as ETFs, allowing investors to trade volatility or to gain exposure to a particular investment strategy, such as currency carry or covered call writing.
- Bond ETFs: These include virtually every kind of bond available. These include U.S. Treasury, government, corporate, international, high-yield, state and local bonds (called municipal bonds) and several more.
- Commodity ETFs: These track the price of a commodity such as gold (GLD), silver (SLV), oil (OIH) or corn (CORN).
- Currency ETFs: These invest in foreign currencies such as the Australian dollar (AUD), Euro (EUR), Japanese Yen (JPY) or US dollar (USD).
- Exchange-Traded Notes: These are essentially debt securities backed up by the issuing bank’s creditworthiness. They were created to provide access to illiquid markets and to provide the added benefit of generating virtually no short term capital gains taxes.
- Foreign Market ETFs: These track non-U.S. markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index.
- Industry ETFs: These track specific industries such as technology, banking, or the oil and gas sector.
- Inverse ETFs: These are set up to move in the opposite direction to the underlying index in order to profit from a decline in the underlying market or index by shorting stocks.
- Market ETFs: These track a particular index such as the Dow Jones, FTSE, NASDAQ and S&P 500.
- Sector and Industry ETFs: These track a specific industry such as oil, pharmaceuticals, or high technology.
- Style ETFs: These track an asset class, investment approach or market capitalization focus, such as large-cap value or small-cap growth.
The manner in which ETFs target asset classes also differs. Some ETFs create the broadest possible swath of investments in a given asset class, to offer an entire market in a single fund. Other ETFs drill down on particular subsectors of an asset class, enabling you to benefit from favourable trends in an industry or type of company, over rivals or companies in completely different areas of the market.
While investors gain as ETF stock prices rise and fall, they also benefit from companies that pay dividends. Some companies pay out dividends as a portion of their earnings to investors for holding their stock. Dividends are accumulated over short periods of time and are then distributed at regular intervals, such as quarterly or annually. However, be aware that tax liabilities are also passed to investors.
The value of the ETF is established by tracking an underlying fund that it uses as it’s benchmark. The oldest surviving and most widely known ETF, SPDR S&P 500 (SPY), tracks the S&P 500 Index.
Management fees for ETFs are typically low, since they track an index, making this a passively managed fund and is therefore less time consuming. The fees for actively managed ETFs cost more. Yet, because of the widespread popularity of ETFs, some brokers waver their commission fees, to provide the ETF and the broker with a competitive edge. Even if you do end up paying a commission, the rise of discount brokers has made it a lot more cost effective than it has been in the past.
It is important to determine your investment goals before buying or selling ETFs. Exchange-traded funds can be utilized to gain exposure to virtually any sector or any market anywhere in the world. You can invest using stock index or bond ETFs, both regarded as low risk. You can also add alternative assets to your portfolio such as gold, commodities, or emerging stock markets. Unlike mutual funds that are only traded at the end of the day, ETFs are traded throughout the day, enabling you to move in and out of markets quickly and catching shorter term swings. Considering the many different types of exchange-traded funds that are available on the market today, ETFs give you enormous flexibility to be the kind of investor that you want to be.