INVESTING IN ETF

Understanding ETFs, What The Heck Are They?

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Last Updated on January 29, 2021 by Yetty Akindele

When you hear ETFs, what comes to mind?  Electronic transfer funds?

Not a lot of people know what this is. However, that’s what I am here for. To give insight into certain aspects of financial matters. ETFs are one of the most crucial and important investment options available to investors in recent years. In full terms, it is known as an Exchange Traded Fund. It has plenty of benefits to provide. If used smartly and strategically, ETFs can make a massive difference in helping you as an investor achieve your goals. In case you’re interested in finding ways to multiply your money via investment options, you’ve come to the right place.

What Is An ETF?

Essentially, an ETF is considered to be a collection of securities that can be bought or sold via a brokerage firm on a stock exchange. It is a bucket of tens, hundreds, or on some occasions, even thousands of bonds or stocks present within a single fund. They’re available on more or less every single asset class, all the way from traditional investments to alternative ones such as currencies or commodities. ETF structures also help investors by giving them options to gain leverage, short markets, and help them manage to avoid short-term capital gain taxes. 

It took a while for the concept of ETFs to kick off, but it eventually managed to do so in 1993. ETFs were popularly associated with the ticker symbol, SPY (also known as “Spiders”), which ended up becoming the highest volume ETF ever in history. This resulted in around 1,000 ETF products being traded on the stock exchange. 

If you’ve ever traded an individual stock, then the purchasing and selling of an ETF will be a simple job as the processes for both of them are fairly similar. It also shares similarities with processes involving mutual funds (index funds, especially). Thus, if you’ve ever traded in those, owning an ETF will feel convenient and comfortable as it comes with the same low costs and built-in diversification. As a matter of fact, you can purchase for free using Questrade

Investing in ETFs is particularly attractive for the young folks. This is because investing in ETFs comes with a low fee. Additionally, you can invest in ETFs with a small amount of capital and liquidity can also be done easily.

Types Of ETFs

There are quite a few different types of ETFs out there. Below, I will break them down to help keep things as simple as possible!

Style ETFs

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The purpose of this is to track a market capitalization concentration or investment using a specific style approach. They are designed to monitor a specific asset class.

Alternative Investment ETFs

These are innovative ETFs that help investors gain exposure to a specific investment strategy or trade volatility.

Commodity ETFs

These aim at specific areas of the market. Purchasing a commodity ETF is unique in that you are not making a physical purchase of the commodity. What you pay for is a stimulated price of the product. Simply put, when you invest in a commodity ETF such as the purchase of energy, your money is invested without you owning an energy plant.

Actively Managed ETFs

These have been created to help with outperforming an index. They’re different from most ETFs, as their purpose is to track an index instead.

Bond ETFs

These have been designed for the provision of every single bond type available out there. 

Exchange-traded Notes

These are debt securities carrying the creditworthiness of the issuing bank. They have a creation for the provision of access to illiquid markets and come with the advantage of procuring no short-term capital gain taxes.

Inverse ETFs

The purpose of these is to help investors profit from a downfall in the index or underlying market.

Market ETFs

These are meant to track a particular index, such as NASDAQ and the S&P 500.

Foreign Market ETFs

These help with tracking non-US markets, like Hong Kong’s Hang Seng index, or Japan’s Nikkei index. 

Sector and Industry ETFs

These assist in providing exposure to particular industries, such as high technology, pharmaceuticals, etc. 

All investors should particularly be aware of inverse ETFs. These are essentially exchange-traded notes, not true ETFs. An ETN works like a bond, with the exception that it’s backed by issuers such as banks. You can also trade it like a stock. I would suggest that you contact your broker to see if an ETN would be a good addition to your portfolio. 

Every country handles ETFs in different ways. In the United States, most ETFs are established as open-ended funds, which are managed by the Investment Company Act of 1940. Hence, it’s a good idea to read up on the Act if you’re planning on getting ETFs in the US. Keep in mind that open-end funds have no restriction on the number of investors that can be involved.

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How Do ETFs Work?

ETFs can be bought and sold just like normal company stocks during the day while the stock exchanges are open. Like stocks, an ETF has a ticker symbol, and its intraday price data can be tracked down during the day. 

ETFs have been created for individual investors, but institutional investors have an important part to play in tracking the integrity of an ETF and maintaining the liquidity through the buying and selling of creation units (large chunks of ETF shares that have the option of being exchanged for collections of the underlying securities). Once the price of an ETF ends up straying from the underlying asset value, institutions adopt the arbitrage mechanism in order to ensure that they bring the price of the ETF back in line with the underlying asset value.

There is one difference between ETFs and company stock. The number of outstanding shares of an ETF can alter daily due to the constant creation of new shares alongside the redemption of existing shares. Since an ETF can be issued and redeemed on an ongoing basis, it can conform its market price to its underlying securities. 

Why Choose An ETF?

There are several reasons as to why you should choose an ETF. To break it down, I have listed these reasons down below. 

1. Tax Benefits

First of all, there can be tax benefits in the picture. Compared to mutual funds, ETFs are more tax efficient. For instance, the underlying assets in an ETF are traded less frequently compared to assets in a mutual fund. Consequently, investors with an ETF will only be taxed when gains are redeemed. Thus, enabling you to decide when to get taxed.

2. Transparency

Transparency is a significant advantage too. As long as you have internet access, you can easily look up the price activity of a specific ETF on exchange. With ETFs, fund holdings are always exposed to the public. This happens on a monthly or quarterly basis with mutual funds.

3. Diversification

Diversification is a pro of ETFs as well. You might think of diversification while considering broad market verticals such as bonds or stocks. But, ETFs particularly stand out as they allow investors to diversify across horizontals too. It usually takes a fair amount of investment and effort to purchase all of the elements of a basket – but all you need to do is purchase an ETF with a single click. You’ll obtain all of these benefits as an addition. 

4. Lower Fees

ETFs, come with the benefits of lower fees. This is because there isn’t a sales load, although brokerage commissions may apply. You can also buy and sell them at any time of the day. While, on the other hand, you can only settle mutual funds after the market close.

Look Out For The Following

There are a few concerns when it comes to using ETFs, which are important for you to keep in mind as well. 

1. Tracking Errors

For starters, there can be tracking errors. Even though ETFs usually track their underlying index considerably well, there can be technical problems resulting in discrepancies. It should be noted that settlement dates could be an issue. ETF sales aren’t usually settled for at least 2 days after a transaction has been completed. Due to this, as the seller, your funds from an ETF sale will not be available for reinvesting for at least 2 days. 

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2. Illiquidity

Illiquidity is a factor too. A few thinly traded ETFs usually tend to have wide bid/ask spread. As a result, you can find yourself buying at the high price of the spread but, unfortunately, selling at the low price of the spread. Additionally, consider the trading costs involved. If you are someone who prefers to invest small amounts over time, you are likely to be at a disadvantage.

3. Closing of ETFs

ETFs are also risky because they may close if a fund can’t bring in enough assets to cover their costs. In this scenario, investors may find themselves needing to sell assets sooner than they planned. If prices are not high enough at the time, you may incur a loss. Having to reinvest the money can also be inconvenient and you may be faced with an unplanned tax burden as well. 

Conclusion

There are a number of ways you can invest in ETFs. Online platforms such as Questrade and Wealthsimple have made DIY investing really simple. However, before you get into investing in ETFs – understand if an ETF is good for your portfolio or not. Conduct your research based on trends before investing. Alternatively, you can contact your financial advisors to assess what the best course of action might be. Coming here is a good start – now, it is time for you to look into the matter even more! 

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