Exchange-Traded Funds (ETFs): What Are They?

Exchange-Traded Funds (ETFs): What Are They?

A type of financial vehicle known as an exchange-traded fund (ETF) collects assets under one roof and passively follows an underlying benchmark index, such as the S&P 500.

Definition and Examples of Exchange Traded Funds

ETFs are collections of securities that include a variety of assets, including stocks, bonds, and gold, making them comparable to mutual funds, particularly index funds. ETFs move similarly to stocks, as opposed to mutual funds, so investors can purchase and sell shares on a market. ETFs are useful tools for investing in a variety of markets, including broad market indices like the S&P 500, industries like technology or health, and even sub-industries like social media or robotics.

The Vanguard S&P 500 ETF (VOO), which invests in the equities of the 500 businesses included in the S&P 500 index, is one well-known ETF. The ETF is a passively managed fund, which means that no active stock trading takes place. Instead, by owning all of its securities at the same percentage weight as the index, the VOO replicates the performance of the S&P 500. For instance, as of February 2022, the financial sector represented 11.50 percent of the S&P 500 and 11.50 percent of the VOO ETF.

These are some further ETF examples:

  • Schwab U.S. Large-Cap ETF (SCHX)
  • Global X Robotics & Artificial Intelligence ETF (BOTZ)
  • iShares Global Clean Energy ETF (ICLN)

How ETFs Work

During regular trading hours, purchasing and selling ETFs can be as simple as purchasing stock through a brokerage account. Like with a stock, you must decide on a specific number of shares to buy or sell when conducting an ETF order. For instance, if an ETF trades for $100 per share and you want to purchase $1,000 worth of it, you’ll need to use the ETF’s ticker symbol to place a buy order for 10 shares.

Although ETFs trade on an exchange like stocks do, they have a special method for issuing and redeeming shares. The buying and selling of the underlying stocks for the ETF is handled by a third party known as authorized participants (APs), typically in sizable shares known as creation units. In this manner, regardless of supply and demand, the price of the fund remains closely correlated to the price of the underlying index without the ETF bearing those trading costs.



Pros and Cons of ETFs

For all sorts of investors, ETFs can be wise financial tools. They might not, however, be the best option for everyone. Knowing the benefits and drawbacks of ETFs is a good idea before investing.

Pros

  • Diversification
  • Low cost
  • Tax efficiency
  • Market orders

Cons

  • Trading costs can add up
  • May be narrowly focused
  • Temptation to trade

Pros Explained

  • Diversification: One ETF gives investors access to dozens or perhaps hundreds of equities or bonds. Comparatively to purchasing just one or a small number of individual assets, holding a variety of investment instruments in a single fund decreases volatility.
  • Low cost: Since the majority of ETFs are passively managed, less expensive research and analysis are not required, which lowers management expenses. On average, expense ratios for ETFs are far lower than those for mutual funds. The average expense ratio for an ETF is less than 0.25 percent ($25 for every $10,000 invested). The fee ratio for the typical mutual fund, in contrast, is around 0.76 percent.
  • Tax efficiency: Mutual funds that are actively managed exchange their holdings, generating capital gains distributions that are frequently taxable to the shareholder. Even though ETF gains are taxed as well, they are typically more tax-efficient than mutual funds due to their structure.
  • Market orders: An investor can put market orders, such as stop-loss orders and limit orders, since ETFs trade continuously on exchanges.

Cons Explained

  • Trading costs can add up: Every time an investor buys or sells shares of an ETF, a small trading commission is occasionally generated. Although the commission costs are minimal, if you make a lot of deals, they soon mount up.
  • May be too narrowly focused: Many exchange-traded funds (ETFs) follow a certain sector benchmark or another specialized market segment, like technology. These ETFs frequently experience greater price fluctuations than a market-wide index like the S&P 500.
  • The temptation to trade: Being able to purchase and sell quickly can urge one to experiment with market timing, which can be more detrimental than beneficial. It makes consumers speculate on price fluctuations rather than make long-term investments.

Key Takeaways

  • A passively tracked underlying index, such as the S&P 500, is what an exchange-traded fund (ETF) uses to aggregate assets together.
  • Due to their passive management, ETFs have lower expense ratios than mutual funds.
  • Hundreds of equities are accessible to investors through an ETF, assisting in diversification.
  • ETFs are a practical way to invest in a large number of equities, such as an index, or to follow a particular industry.
  • The convenience of trading ETFs, however, can tempt investors to attempt and time the market by buying and selling them, and the funds they hold may be too narrowly focused.

Leave a Reply