As you start to consider all of your options in investments, you may hear about exchange-traded funds or ETFs. This is a specific type of investment available to many people. It is designed, in part, to make investing in stocks a bit easier. It is always wise, though, if you are considering the investment in ETFs or any other investment type, speak to your financial investor. There are risks associated with these accounts. You should understand them and know what to expect when you choose this investment strategy.

It is important to learn more about ETFs. Over the last ten or so years, the number of people investing in these funds has grown rapidly. The amount of money in these funds grew from 7 billion in 2008 up to 5.1 trillion by 2018. As a result of this growth, and because this has become a sought after way of investing, it is critical that those interested in investing take a closer look at how this particular investment can work for their needs.

How Does an ETF Work?

An ETF is a type of fund. That means it is a collection of securities or investment types. This can include stocks and bonds, though many of them are collections of stocks. They can also include commodities or any real mixture of investments. The fund tracks an underlying index. The most common fund is the SPDR S&P 500 ETF. This particular fund tracks the S&P 500 Index. When choosing any fund to invest in, you will need to consider the underlying index it tracks. That helps to determine the overall risk and earning a potential present.

Why Should You Consider ETFs?

There are many reasons to choose this type of investment strategy. However, many people do it because it offers diversification. This is important for all investors. For example, if you put all of your investment money into one company, and that company did well, your growth would be fantastic. However, if that company did poorly in the market, perhaps due to a scandal or a change in the economic climate, that would cause your investment value to drop significantly or even be eliminated.

With diversification, that is stable. The underlying investments can do well or bad, but generally, they continue in positive territory. Because ETFs are made up of a number of different investments, then, they are able to provide you with more of the diversification that most people need to have within their portfolio.

Is an ETF Safe, Then?

While diversification is an important component of an ETF, that does not make it a safe investment. All investments, especially those in relation to stocks, are going to have some level of risk associated with them. The good news is that they can be somewhat less of a risk for many people. It is important to understand your personal risk tolerance and to make decisions about what type of investing is right for your long-term goals.

However, because ETFs offer diversification options, and they are easy to trade, many people prefer them over traditional stock investing. They can also work as a long-term tool. Many people find that they are a good way to put money aside that you want to see grow, but will not need to access for some time.

Breaking Down the ETF

All investments carry risk. What an ETF does is provide you with a way to invest in a lot of smaller securities – like bonds, stocks, and commodities – without having to make numerous trades. It’s like investing in a full basket of options rather than just one. That means you cannot buy individual stocks and bonds from them, though. You buy what is included in the ETF.

How Do You Buy Them?

Usually, this is done through a brokerage firm. Generally, the provider of the ETF owns the assets – or the underlying securities in the ETF. Then, that provider or owner sells the shares of the fund – not necessarily the investments in the fund – to others. Investors, like you, are able to buy the shares of the ETF they want to own. This is done in much the same way as you would buy shares of a company when buying stocks.

Every time you buy a share of the ETF, you are buying a portion of the fund. The fund, again, is the investment basket that holds other stocks and bonds. When you buy a share, you are not buying any ownership into the actual stocks and bonds within the fund. This may sound a bit confusing, but instead of viewing it as you are buying stocks, view it as you are buying shares in a fund.

You get to buy and sell shares in the fund using a stock exchange. What makes these funds so unique is that they let you short markets. They also allow you to gain leverage. Most of the time, they allow you to minimize any short term capital gains taxes you would have had to pay if you had purchased the stocks outright. It is all of these benefits that make this type of investment strategy an ideal option for many.

Which Type of ETF Will You Buy?

There are many types of ETFs available today. It is up to you to choose which one is best for your investment goals. You have lots of flexibility and that is a good thing. It allows you to choose the type of ETF and the risk that is right for your needs. You can buy an ETF that only has stock in it. While it only has stock, it is not made up of just a single company’s stock. Rather, it has multiple companies presented in the fund. This is what helps you to diversify. You can choose from other types of ETFs as well.

Here is a look at some of the types of ETFs being invested in today. There may be others as well.

Bond ETFs

This type of ETF usually includes an assortment of bonds. This can include corporate bonds, but usually includes government bonds and municipal bonds. Municipal bonds are those issued by states or cities.

Industry ETFs

This type of ETF generally includes stocks in companies within the same industry. They track various industries. For example, some are focused on financials, such as banks. Others are focused on the oil and gas sector, on technology, or other specific types of commodities.

Commodity ETFs

Most of the time, these are based on hard commodities. Common ETFs in this area include crude oil and gold ETFs. They track these industries specifically.

Currency ETFs

These types of ETFs invest in currencies. Generally, they invest in currencies such as the Euro and Canadian dollar. Other currencies may also be represented.

Inverse ETFs

This is a more complex form of ETF and may not be right for everyone. This type of ETF has the goal of earning growth from declines that occur in stocks by shorting stocks. The process of shorting a stock involves selling the stock and expected a drop in the value of the stock as a result. Then, it involves repurchasing that stock at a lower price point.

How ETFs Grow in Value and Are Traded

ETFs can become confusing because of how they are designed. However, the work must like traditional purchases and sales of shares on the stock market. First, you can buy and sell the shares you desire using the stock market. Every ETF is represented on a stock market. Each one has its own ticker symbol, as well. Like with the traditional stock market, buying and selling ETFs happens only when the market is open. And, you can track how well your ETFs are doing throughout the day on the stock market by looking for the ticker symbol.

As the ETFs is bought and sold, that is going to change the value of the fund. Of course, you want there to be more demand for the fund, as that would push the value of your shares higher. If the underlying investments do poorly, or the fund is no longer desirable for some reason, that can cause the value of the fund to drop. A lot of times, this follows the same overall pattern of the stock market.

The Underlying Investments Change, Too

To make matters a bit more complex, the investments inside of the ETF can also change. This includes the stocks that are within the fund. For example, let’s say a bank provides stock to be put into the fund. This is added to the “basket” of stocks held within the fund. That means that ETF owns the stock shares in the bank. And, as a result, this means there are more shares in the fund. And it means that you can buy more shares.

In this way, when more assets are added to the fund – like stocks in another company – the more ETF shares are available for you or other people to purchase. The same is true on the other side.

Let’s say the bank wants to sell some of the ETF shares. This would mean that investors would get the stocks back that were represented in the food. The number of shares, then, within the fund or basket, are fewer now.

How Buying and Selling Impacts the Fund

When the price of the fund is different from the value of the stocks and bonds within it, that is when buying and selling typically happens. When people – you or other investors – buy and sell their shares of the fund, that will change the value of the underlying investments or assets within the fund.

The up and down movement of the value of the assets helps to keep the ETF’s market price in line. That is what helps to make this investment a bit more stable than others that you may find.

How Do ETFs Compare to Mutual Funds?

If you have any experience in investing, you may think that ETFs seem to work a lot like mutual funds. They do offer some similar traits. For example, both mutual funds and ETFs have a set of individual stocks and bonds within them. In this way, both funds have the ability to be easily purchased and invested in by most consumers. Both offer the diversification that many people are looking for when investing in these types of strategies.

How They Differ

However, mutual funds are a bit different. ETFs are traded along the same way as stocks are bought and sold. With ETFs, you can buy and sell the shares in the fund like you would traditional shares in stocks. You can do this throughout the day, too. The value of each of the shares you buy is dependent on what investors think the underlying investments – the assets – in the fund are worth.

What is different, though, is the way mutual funds are managed. In a mutual fund, the sale or the purchase of the stocks within the fund happens after the normal trading day is over. The value of the mutual fund is determined in a different manner as well. In a mutual fund, the value is dependent on the Net Asset Value. This is calculated by subtracting all of the liabilities from the assets. Then, you divide that number by the total number of shares within the fund.

Also, ETFs may be a better option for those who want to know what is happening with their investments more readily. Because the buying and selling of ETFs happen during the day, you can see – at any time – what the value of the ETFs are and what they are selling for. That is not the same with mutual funds. It is much harder to see what factors are impacting mutual funds. That is because most mutual funds only release information about this at the time of reporting, which may happen only quarterly or less frequently.

Common Questions About ETFs

It is important to make your own decisions up about ETFs or other types of trading vehicles. Here are some common questions asked about this particular type of fund.

Why Should You Consider ETFs?

You have a lot of options out there, but ETFs offer some key benefits. For example, there are no capital gains paid on the sale of ETFs. There are capital gains – a type of tax you must pay if the value of your investment grows within the calendar year – on mutual funds. This can make them a bit better for those who want tax reduction strategies.

How Do You Buy ETFs?

Most of the time, you will buy or sell ETFs through your brokerage or retirement accounts such as Roth IRA, Traditional IRA or 401(k). But, your brokerage account, no matter how you obtain one, will buy and sell the ETFs on the open stock market. It is important to consider any fees associated with the process. These can have many.

When Should You Keep ETFs in Your Portfolio?

Many people will benefit from adding ETFs to their investment goals. Because of the diversification they offer, they can prove to be a good option in most economic climates. Yet, it is important to consider all aspects of risk associated with these types of investments, as you would any time you invest.

Author

Edwin is the founder of Voy Media. He started his career at an investment bank before moving to the biopharmaceutical industry. He is currently an editor at Dollar Genie, a finance blog that teaches you how to save money, make money, and live well.

Write A Comment