Exchange-Traded Funds (ETFs) have taken the investment industry by storm in recent years. For individual investors who are searching for new ways to achieve their financial goals, ETFs can offer a cost-effective solution and help meet various financial needs.
This quick guide is intended for people who need a beginner’s introduction to what ETFs are and how they work. Keep in mind, if you are completely new to the investing world, you might first want to check out our previous article called the 4 Important Tips For Beginner Investors.
So What Exactly Are ETFs?
To understand what ETFs are, you first need to know how mutual funds work. A mutual fund is a type of investment vehicle where individual investors put their funds into a pool of money made up by securities such as stocks, bonds, and other related assets. This pool of funds is generally managed by professionals who study market movements on a daily basis and know the ins and outs of major industry trends.
While investing through mutual funds is a great option especially for young investors, it unfortunately has some major downsides. Mutual fund fees, which include management fees and sales charge, can eat into gains. Furthermore, investors have a limited option about which stocks to buy or sell. For example, even if an investor wants to buy a certain stock, if the fund manager disagrees, he or she cannot make that particular decision.
This brings us to exchange-traded funds, or otherwise known as ETFs. ETFs share a similar characteristic to both mutual funds and individual stocks. Just like a mutual fund, ETFs include a shared pool of investment vehicle that holds a list of securities. But unlike mutual funds, investors can trade ETFs like common stocks multiple times throughout the day. One study shows that 70% of active fund managers eventually underperform market indexes like the S&P 500. Thus, people who invest in ETFs and follow the general market indexes can actually end up outperforming these fund managers.
Are There Different Types of ETFs?
There are several types of ETFs: Bond ETFs, Commodity ETFs, and Foreign Market ETFs. Just as the name suggests, these ETFs have unique characteristics that focus on specific types of assets. For example, Foreign Market ETFs only focus on stocks that are outside of the U.S., while Bond ETFs focus on the different types of bonds and Commodity ETFs focus on the prices of commodities such as gold or oil.
Aside from the ones mentioned above, there are two major types of ETFs: Market ETFs and Sector ETFs. With Market ETFs, one may invest in stocks that reflect an entire performance of stock indexes. For example, if you don’t have the capital to purchase all the individual stocks listed under a certain index, Market ETFs allow you to follow that index at a fraction of the cost. So instead of purchasing all 500 stocks listed under the S&P 500, you can just purchase what’s called the SPY ETF. The symbols for the Dow Jones Industrial Average and the NASDAQ are DIA and QQQ respectively.
The second type are the Sector ETFs. To simply put, these ETFs allow you to choose stocks under a specific industry. For example, let’s say you want to invest in stocks related to the tech industry. One of the most popular tech ETFs is called XLK, which has blue-chip stocks like Apple, Microsoft Corp., and Facebook in its portfolio. A big reason why many people choose to invest in Sector ETFs is because of diversification. 33% of stocks in the S&P 500 are listed as financial stocks. So even if you purchase SPY ETF, you would still need to diversify your portfolio and branch out to different sectors to avoid more risks.
What Are the Pros & Cons of ETFs?
Pros:
- Liquidity — ETFs can be traded like common stocks. This means you can buy and sell at any time of the day with real-time prices, unlike mutual funds where you have to wait until the end of the trading day.
- Cheap — Compared to mutual funds, the transaction fees are significantly lower. According to the Wall Street Journal, ETF has an expense ratio of 0.44% — for every $1,000 dollars you invest, you’ll need to pay a fee of $4.40. For mutual funds, the average equity management fee is about 1.40%.
- Diversification — If you purchase an ETF, you aren’t investing in just one particular company. You are essentially buying an entire industry or sector, which means you’ll have more chances to diversify your portfolio.
Cons:
- Limitation — ETFs are generally more readily available in the U.S. stock market. Hence, if you are outside the country, you’ll be left with limited choices. Furthermore, you won’t have any chance to actively choose an investing strategy with ETFs. Instead, you will likely have more choices with managed funds.
- Costly — This depends on how often you trade throughout the day. For mutual funds you only pay the management/performance fee once. But for ETFs, you’ll get charged a transaction fee each time you trade on the stock exchange.
Should You Invest in ETFs?
Depends.
Before you decide to invest in ETFs, think about what your investing goals are. If you think investing in ETFs can help you achieve your goals faster, than why not go for it? Also, you might want to consider how much capital you have before investing. Yes ETFs account for lower fees, but their trading costs can rack up pretty fast. If you are confident in your own ability to make financial choices and you have the time and money to research and follow the markets on your own, then investing in ETFs may not be that helpful. However, if you are hesitant about which stocks to invest in, then choosing an ETF is definitely a better way to go. In whatever the case, the choice is up to you.
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