Introduction To ETFs

What Is an ETF?

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.

A well-known example is the #SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. ETFs can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An exchange traded fund is a marketable security, meaning it has an associated price that allows it to be easily bought and sold.

An #ETF is called an exchange traded fund since it's traded on an exchange just like stocks. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid when compared to mutual funds.

>>>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.

-Bond ETFs might include government bonds, corporate bonds, and state and local bonds—called municipal bonds.

-Industry ETFs track a particular industry such as technology, banking, or the oil and gas sector.

-Commodity ETFs invest in commodities including crude oil or gold.

-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.

Investors should be aware that many inverse ETFs are exchange traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank.2 Be sure to check with your broker to determine if an ETN is a right fit for your portfolio.

In the U.S., most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements.3 Open-end funds do not limit the number of investors involved in the product.

>>>Real-World Examples of ETFs <<<

Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks creating a broad portfolio while others target specific industries.

-SPDR S&P 500 (SPY): The oldest surviving and most widely known ETF tracks the S&P 500 Index

-iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index

-Invesco QQQ (QQQ): Indexes the Nasdaq 100, which typically contains technology stocks

-SPDR Dow Jones Industrial Average (DIA): Represents the 30 stocks of the Dow Jones Industrial Average

-Sector ETFs: Track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH)

-Commodity ETFs: Represent commodity markets including crude oil (USO) and natural gas (UNG)

-Physically-Backed ETFs: The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund

>>Advantages and Disadvantages of ETFs<<

ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually.

Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions since there are only a few trades being done by investors. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.

An ETF's expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses since they track an index. For example, if an ETF tracks the S&P 500 index, it might contain all 500 stocks from the S&P making it a passively-managed fund and less time-intensive. However, not all ETFs track an index in a passive manner.

#1.Pros

-Access to many stocks across various industries

-Low expense ratios and fewer broker commissions.

-Risk management through diversification

-ETFs exist that focus on targeted industries

#2.Cons

-Actively-managed ETFs have higher fees

-Single industry focus ETFs limit diversification

-Lack of liquidity hinders transactions

>>More About ETFs<<

-Actively-Managed ETFs

There are also actively-managed ETFs, where portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively-managed #ETFs. It is important that investors determine how the fund is managed, whether it's actively or passively managed, the resulting expense ratio, and weigh the costs versus the rate of return to make sure it is worth holding.

-Indexed-Stock ETFs

An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share since there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other.

-Dividends and ETFs

While ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value in case the fund is liquidated.

-ETFs and Taxes

An ETF is more tax-efficient than a mutual fund since most buying and selling occurs through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell, or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares they sell it back to the fund and incur a tax liability can be created that must be paid by the shareholders of the fund.

-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.

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability. Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

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