May 2nd, 2022
Exchange-traded funds, or ETFs, can be a great way to broadly explore different sectors of the market while hedging against risk. Because the concept of ETFs can get a bit complex, we will break down what exactly an ETF is, all the different types, and how they can help you invest your money more intelligently.
What is an ETF?
Some might say that an exchange-traded fund is exactly what it sounds like: a fund, or pool of money, that is traded on a stock exchange. While correct, this definition is a bit simplistic and restrictive. Exchange-traded funds can track many different securities, such as a basket of stocks, the price of commodities, or even different currencies. They are an index of the underlying assets, letting those who invest in them know how those assets are performing as a group.
For example, the oldest and most popular stock ETF is the S&P 500, which indexes the stocks of the 500 leading publicly traded companies in the U.S. If you were to invest in the S&P 500 ETF, you are essentially putting your money into 500 different companies all at once. This is how ETFs can be an amazing tool for diversification.
There are two main types of exchange-traded fund: passive and active.
Of the two types of ETF, passive is the fastest growing because it is simpler to manage and takes some anxiety away from the investor. Passive ETFs usually track a single area of the stock market, such as a specific industry or sector. For example, iShares U.S. Technology ETF tracks companies in the technology sector.
Passive ETFs can also focus on commodities like gold or oil, such as the SPDR Gold Shares ETF, which tracks the price of gold bullion.
Another common type of passively managed ETF is a currency ETF, which tracks currency pairs’ relative values. These are great for investors wanting to break into a foreign exchange, or “forex,” market, because the formidable task of making trades is done by the fund, which has access to experts and many resources otherwise unavailable to an individual.
Active ETFs are funds that are actively managed by a portfolio manager who chooses which assets to buy and sell, rather than just focusing on a specific industry or sector. Their holdings change regularly because the manager is moving the money around, trying to maximize returns for their investors. To the financially literate, this may sound a lot like a mutual fund. But what sets ETFs apart from mutual funds?
ETFs vs Mutual Funds
Exchange-traded funds tend to be cheaper than mutual funds because they usually don’t charge a commission on trades, and they are more tax-efficient. ETFs are also much more versatile, in that you can short ETF stocks and buy them on margin, while you are only allowed buy or sell those of a mutual fund. What’s more, ETFs can be traded any time within normal trading hours, while mutual funds must be traded at the end of the trading day (4pm).
Mutual funds often have a required minimum investment because entry is controlled by the overseeing companies like BlackRock or Vanguard, whereas ETFs are publicly traded indexes, available for anyone on the stock market.
Other Types of ETFs
In addition to sector, commodity, and currency ETFs, here are a few more types to help you determine which would be the best option for your investments.
Bond ETFs are passively managed funds that invest in bonds. These funds can track many different types of bonds, such as Treasury, corporate, and municipal bonds. To the average investor, the bond market is fairly difficult to get into, simply because the nature of bonds makes it hard to find a single one worth your investment. Bond ETFs do the legwork for you, and you are paid monthly dividends on interest rates like plain old bonds. Any capital gains on the fund are also paid out as yearly dividends.
Stock ETFs are funds (usually passively managed) that track the performance of a group, or “basket,” of stocks. Like sector ETFs, stock ETFs can focus on one particular area of business, or they may track stocks within their own parameters, like the aforementioned S&P 500 index. Stock ETFs are a good way to hedge against risk because if one of the underlying assets starts to underperform, you have many others to pick up the slack.
Inverse ETFs can be a little confusing to someone who isn’t familiar with financial jargon. The “inverse” in inverse ETFs comes from the fact that you are essentially betting that the underlying assets will decline in value. How does a fund make money from a decline in value? These inverse ETFs employ a strategy called “shorting” to translate that decline into returns for investors. When a fund shorts a stock, they borrow shares from a lender and sell them. That fund now owes those shares back at a later, agreed upon date. Over time (if the fund is lucky), the shares will lose value on the market, and they will buy the shares they owe the lender back at a cheaper price. They then return the shares to the lender and pocket the difference.
Here is an example of shorting a stock: ABC is trading on the stock market at $10 per share. A speculator believes that the stock will decline in value, so they borrow 100 shares of ABC from a lender and sell them on the market. Now the speculator has $1,000. Later, the ABC shares fall to $5. The speculator buys back the 100 shares for a total of $500. They give the 100 ABC shares back to the lender and keep the leftover $500 as profit.
This is a complex and anxiety-inducing process, even to experienced investors, so an inverse ETF is a good way to take some of the pressure off the individual by essentially automating the shorting process and spreading it over the dozens or hundreds of stocks in the ETFs basket.
Leveraged ETFs seek to increase a market’s volatility by multiplying the percent gains or losses of the underlying index. For example, the leveraged ETF called UPRO aims to mirror the S&P 500, but with a 3x leverage. This means that whenever the S&P 500 increases in value by 1%, UPRO will increase by 3%. On the other hand, if the S&P falls by 1%, UPRO will fall by 3%. Leveraged ETFs are relatively high-risk, high-reward endeavors.
In conclusion, investing in an exchange-traded fund is a bit like putting all your eggs in one basket, but in a good way. In this case, the basket is as big as a house, and you have a million different eggs inside. If one of them goes bad, it’s not really that big of a deal, you have 999,999 more. ETFs provide access to a diversified portfolio that will expose investors to entire sectors or industries, while mitigating the risk of choosing which stocks, bonds, commodities, etc. to invest in, all while being cheaper and simpler to follow than mutual funds. For investors of any level, ETFs can be a tremendous asset.
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