A Simple Guide to Understand the Basics of ETFs

Want to invest in funds that are easy and offer multiple benefits? Lucky for you, funds like that exist. ETFs could be your go-to option as they offer the benefits of mutual funds and easy trading like stocks. Here is a simple guide for you to understand everything about ETFs.

What is an ETF?

ETF or Exchange-traded fund is a kind of collection of investment security that functions like a mutual fund. You can make pooled investments such as equities or bonds with an ETF.

Additionally, you can invest in a diverse number of securities at once. ETFs are carved to track specific investment strategies.

They are easy to trade and come at lower fees than other funds purchased individually.

Moreover, ETF share prices fluctuate all day, unlike mutual funds, where you can trade once a day after the market closes.

Like all other investments, ETFs must be meticulously looked into before investing. The pros and cons, including management charges, fee comparison, investment quality, etc. must be checked before making a final decision.

How do ETFs function?

What makes ETF unique is the diverse assets it carries, such as stocks, commodities, currencies, bonds, and various other investment kinds. It makes a basket of securities.

Depending on your need, you can choose funds that focus on securities offered on a global scale or specifically in the U.S.

Like stocks, you can buy and trade ETFs throughout the day.

Types of ETFs

Generally, ETFs are broadly categorized into passive or active. Different kinds of ETFs are available today. Most of the ETFs are index-based based on stocks and a bond index.

Difference between passive and active ETF

• Passive ETF

Passive ETF tracks an index or specific benchmark. This can be a stock market index, custom-built or fixed income, commodities, and currency. Moreover, they mimic the index by buying all securities that the index comprises, or they can be customized by buying securities in that index that is most suitable based on exposure and risk.

• Active ETF

A portfolio manager undertakes stock research in an Active ETF. In active ETFs, one of the investment strategies is used to outshine a benchmark. That’s where the key difference between active and passive ETFs lies. You can actively manage active ETFs to excel in investment to get more returns. Taking advantage of opportunities when markets move and managing the portfolio’s risk are key components of active ETFs.
Another difference is that passive ETFs lean towards lower costs and more transparency than active ETFs. But unlike active ETFs, passive ETFs do not provide scope to outshine.

Different types of ETFs

Let’s explore different types of ETFs.

• Bond ETFs

Bond ETFs are fixed-income assets and low-risk investment avenues. They are similar to ETFs because they make a correlating index or underlying investment product. Since they are fixed-income assets, they aren’t liquid. Therefore, investors hold them until they mature and don’t trade them on markets such as stocks and indexes. Similar to mutual funds, bond ETF invests in a basket of bonds. Types of bond ETFs include Government bond ETFs, Corporate bond ETFs, and broad market bond ETFs.

• Stock ETFs

Stock ETF invests in a basket of stocks tracking a single sector. Stock ETFs aim to offer myriad options for a single industry or sector. Additionally, it provides growth opportunities and comes at lower costs.

• Sector ETFs

In these funds, the focus is on a specific sector. This includes tracking the performance of top companies functioning in that specific sector. Thereby gaining exposure to the benefits and growth in that arena. For example, the Tech sector will involve companies operating in that sector. But they do not include direct ownership of securities.

• Commodity ETFs

Commodity ETFs focus on tracking the performance of a specific commodity or set of commodities. This could include valuable metals like gold and silver, agricultural goods, and natural resources such as oil and gas. An investor buying a commodity ETF owns a set of contracts backed by a commodity instead of a physical asset. Commodity ETFs are highly liquid securities.

• Currency ETFs

Currency ETFs are pooled investments that offer investors exposure to forex or currencies. These investments are held in a single country or basket of currencies and are commonly managed passively. Foreign exchange, or forex, is the largest market for trading currencies. Therefore, it is a good way for investors to involve themselves in trading currencies. Currency ETFs let investors get exposure to changes in exchange rates in one or more currency pairs. The exposure of investment to forex is strategic in currency ETF through a portfolio of currencies.

• Inverse ETFs

Inverse ETFs aim to gain returns in opposite proportions to a target market index by investing in swaps. To clarify, investors bet against the market and buy inverse ETFs. They make gains out of declines. So, if an investor owns an inverse ETF of a target index or asset class and it declines, the investors gain from that asset class’s decline. These are best for experienced investors because experts suggest not holding them longer than one day as it impacts returns.

How to buy ETFs?

There are many ways to invest in ETFs, but ultimately, it comes down to your preference.

• Create a brokerage account to meet your goals

Firstly find out a suitable investing platform. Most online investing platforms provide ETFs, and many of them come at zero cost or meager costs. You don’t have to pay fees to most of these online platforms to buy or sell ETFs. The main types of brokerage accounts are taxable, retirement, 529, and custodial.

If picking out ETFs on your own is an overwhelming task for you, then consider Robo-advisors. You can get automated portfolio rebalancing as they customize low-fees and multiple ETF portfolios.

• Research ETFs

Secondly, research ETFs. Ask yourself the goals you have and, depending on them, make investments in ETFs. There are plenty of available ETFs today. Committing to an ETF involves researching them thoroughly. Keeping your goals in mind, note the indexes and fees of the ETFs. What is the main goal for your investment? Are you looking for risk-free or low-risk sectors? And go over the various types of ETFs and choose the one that fits your focus and interest best.

• Come up with a trading strategy depending on your level of expertise

Finally, come up with a suitable strategy. If you are only beginning, you might want to focus on low-risk ETFs that offer regular income returns. After that, you can transition to others with risk but higher returns.

Pros and Cons of ETFs

The pros of ETFs include diversification, lower costs, liquidity, exotic investments, and the ability to buy in small amounts. In contrast, the cons include limited or over-diversification, higher fees, and lack of liquidity.

Pros	Cons
Diversification ETFs provide exposure to a variety of sectors, industries, and stocks. Exposure to a wide variety of equities or they even mimic the results of international as well as specific countries.	Limited diversification Some ETFs focus on a single industry or sector, limiting diversification.  Over-diversification Many ETFs indulge in over-diversification. As most ETFs are passively managed, they follow a specific index. This results in, sometimes, them not owning the best stocks.
Lower costs  ETFs that are passively managed have lower cost ratios than mutual funds. All in all, broker commissions are also fewer because investors carry out transactions only to buy and sell.	Higher fees Actively managed ETFs come at a higher fee.
Liquidity  ETFs can be traded anytime during the day, not just at the end of the day. This is one of the benefits when the volatility is high.	Lack of Liquidity  Some ETFs lack liquidity that curbs transactions.

Additional perks of ETFs

ETFs and Dividends

ETFs do pay dividends depending on the underlying stocks. If the underlying stocks pay dividends, then ETF also pays dividends. But if it doesn’t, then ETF also won’t offer it. To clarify, if you purchase an ETF and its underlying sector or company pays dividends, your ETF will also offer it.

You can buy and sell ETFs anytime

Like stocks, you can buy and sell ETFs anytime throughout the day. As an investor, you can benefit from intraday price fluctuations.  This is unlike mutual funds, where you can only buy at the end of the day, and the price is calculated after the market closes.

Conclusion

ETFs or exchange-traded funds offer pros as well as cons. Therefore, you must research them meticulously like any other investment. Since there are a wide variety of ETFs available, you can easily choose the one which resonates with your investment goals the most. Now that you have understood what ETFs are, how they work, their types, how to invest in them, and their advantages and disadvantages, it might help you choose better.