Investing with ETF

Want the ease of stock trading, but diversification benefits of mutual funds? Take a look at exchange-traded funds (ETFs), which combine the best attributes of both assets.

What Is an ETF?

An exchange-traded fund — better known by the acronym “ETF” — is a fund that can be traded on an exchange like a stock (hence the name). ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually.

An exchange traded fund (ETF) is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies. ETFs are in many ways similar to mutual funds; however, they are listed on exchanges and ETF shares trade throughout the day just like ordinary stock.

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock. Because there are multiple assets within an ETF, they can be a popular choice for diversification.

Types of ETFs

There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor’s portfolio. Below are several examples of the types of ETFs.

Types of ETFs

• Market ETFs: Designed to track a particular index like the S&P 500 or NASDAQ
• Bond ETFs: Designed to provide exposure to virtually every type of bond available; US Treasury, corporate, municipal, international, high-yield and several more
• Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology
• Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn
• Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
• Foreign market ETFs: Designed to track non-US markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index
• Inverse ETFs: Designed to profit from a decline in the underlying market or index
• Actively managed ETFs: Designed to outperform an index, unlike most ETFs, which are designed to track an index
• Exchange-traded notes (ETNs): In essence, debt securities backed by the creditworthiness of the issuing bank, which were created to provide access to illiquid markets; they have the added benefit of generating virtually no short-term capital gains taxes
• Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing
• Industry ETFs: track a particular industry such as technology, banking, or the oil and gas sector.
• Currency ETFs invest in foreign currencies such as the Euro or Canadian dollar.
• Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price.

How ETFs work

An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day.

Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.

Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.

How to Buy and Sell ETFs

ETFs trade through online brokers, most banks and traditional broker-dealers.

Advantages of ETFs

The appeal of ETFs:

• Easy to trade – You can buy and sell any time of the day, unlike most mutual funds that trade at the end of the day
• Transparency – Many ETFs are indexed based; index-based ETFs are required to publish their holdings daily
• More tax efficient – ETFs typically generate a lower level of capital gain distributions relative to actively managed mutual funds
• Trading transactions – Because they are traded like stocks, investors can place a variety of order types (e.g., limit orders or stop-loss orders) that can’t be made with mutual funds

Disadvantages of ETFs

However, ETFs do have drawbacks, including:

• Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund
• Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread
• Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies
• Settlement dates: ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale aren’t technically available to reinvest for 2 days.

Investing strategies

Once you’ve determined your investment goals, ETFs can be used to gain exposure to virtually any market in the world or any industry sector. You can invest your assets in a conventional fashion using stock index and bond ETFs, and adjust the allocation in accordance with changes in your risk tolerance and goals. You can add alternative assets, such as gold, commodities, or emerging stock markets. You can move in and out of markets quickly, hoping to catch shorter term swings, much like a hedge fund. The point is, ETFs give you the flexibility to be any kind of investor that you want to be.

ETFs Market Impact

Since ETFs have become increasingly popular with investors, many new funds have been created resulting in low trading volumes for some of them. The result can lead to investors not being able to buy and sell shares of a low-volume ETF easily.