An exchange-traded fund (ETF) is an investment instrument that comprises a basket of securities, such as stocks, commodities, bonds, currencies, derivative products, and more recently, Bitcoin futures, which can be purchased or sold in a single trade on a stock exchange. ETF shares constitute partial ownership of a portfolio run by fund managers using either a passive- or an active-investing approach.
The SPDR S&P 500 ETF Trust (NYSE:SPY), which tracks the returns of the S&P 500 index, was the first ETF to be launched stateside in 1993. By 2021 there were around 2,700 ETFs listed in the US with around $6.7 trillion under management.
1) Broad-based ETFs that investors can use to diversify their portfolios at low cost
2) Specialized ETFs that are more expensive, but satisfy investors’ appetite for popular – and sometimes overvalued – investing themes.
How do ETFs work?
In the US, the Securities and Exchange Commission (SEC) regulates the creation of ETFs. The ETF manager or sponsor initially buys the underlying securities and sells ETF shares to investors. So, in an equity ETF, investors are not buying shares of a public company but instead units of a fund holding a portfolio of equities.
Like stocks, ETFs have their specific ticker symbols and are bought and sold during a trading day. Financial websites or brokers enable investors to access detailed information and data about the ETF, similar to that displayed for a stock.
Most ETFs are passively managed, tracking the returns of an index. However, there are also actively-managed ETFs that do not necessarily follow an index. In that case, fund managers make regular decisions about what and when to invest.
Meanwhile, unlike company stocks, the supply of ETF shares is more flexible. The number of shares outstanding can vary daily due to the creation of new shares and redemption of existing ones.
Investing in ETFs: Potential Costs
When buying an ETF, market participants need to be aware of various costs, starting with the yearly operating expense charged by the fund manager. Many ETFs have low operating expenses. However, investors need to understand how much they will be charged each year as an ongoing expense.
Then, like shares, ETFs have “bid” and “ask” prices. The difference between them is the “spread.” Popular and heavily traded ETFs typically have narrow spreads. On the other hand, those with low trading volumes or are illiquid usually have wider spreads, increasing the cost to trade the fund.
An additional expense for investors might be the commission charged by brokers. In the US, many brokers do not charge for buying or selling ETFs. However, investors should confirm the fee policy for trading ETFs with their brokers.
Price Difference to NAV
Finally, investors will also notice “premiums” or “discounts” to “Net Asset Value” (NAV), or the total value of all securities in the ETF. The NAV is calculated daily after the close of the market.
If the market price of the ETF is higher than its NAV, the ETF is trading at a premium. Conversely, the ETF trades at a discount when the market price is lower than the NAV.
On most trading days, premiums and discounts, or how much the price of an ETF deviates from the NAV, are negligible and generally self-correcting. But when volatility increases, the difference can also widen.
An ETF’s overview or fact sheet, usually available online, typically shows the performance and whether it strays away from the NAV. Large and widely-held ETFs tend to have negligible price differences to NAV.
An investor’s portfolio strategy is an essential factor in determining the total cost of investing in an ETF.
Why invest in ETFs?
ETFs are available for a large number of asset classes, sectors, or themes. As a result, ETFs enable investors to spread risk over numerous securities and provide built-in diversification.
Easy to Understand
Many investors prefer ETFs as they can be traded daily during market hours, and many have low operating expenses. In addition, most ETFs do not have complex strategies and are also relatively easy to understand. Therefore, they offer even new retail investors a reasonably straightforward way to participate in the growth of various asset classes or investment themes.
As regulated securities, ETFs are typically transparent.
A large number of ETFs also have options available for trading. Thus experienced traders can also set up numerous options strategies using ETFs.
How do leveraged ETFs work?
Leveraged ETFs (or LTEFs) are also increasingly becoming popular with more sophisticated investors, as well as short-term traders. Such ETFs aim to deliver multiples of the return (such as twice or three times) of the benchmark index’s performance on a daily basis.
Using derivative products, such as futures, options or swaps, a leveraged ETF aims to amplify daily index returns by a ratio of 2:1 or 3:1. To maintain the constant leverage ratio, fund managers have to rebalance the leveraged ETF daily.
These funds are not necessarily appropriate for holding periods over a day. But when held over long periods, returns of leveraged ETFs do not fully mirror the returns of their benchmarks.
For instance, a 2x leveraged ETF is designed to be constantly 2X leveraged daily. This fund needs to purchase daily when underlying asset prices increase and sell daily when they decrease. Yet, the compounding effects of such daily returns work against long-term holders of LTEFs.
Leveraged ETFs are typically named “bull” or “bear” funds. Thus, when they buy inverse or bear ETFs, investors can short the index the ETF tracks as well.
Seasoned investors realize that in investing, risk and return go together. The possibility of increased (i.e., 2X, -2X, 3X or -3X) return also means increased risk. When the market moves against the direction of a leveraged ETF, then losses will also be amplified.
Leveraged funds can also contribute to increased market volatility due to additional buying demand or selling pressure, especially at the close of a trading day. The SEC has warned retail investors about the complex structure of leveraged ETFs.
Leveraged ETFs can be appropriate investment vehicles for some market participants. However, investors need to be clear about the potential risks. Interested readers should check the margin requirement to trade leveraged ETFs with their brokers.
Are ETFs a good investment?
- Most ETFs provide diversification at relatively low expense ratios.
- Exchange-traded funds also enable investors to invest in numerous asset classes, industries, or geographies, through their brokerage accounts.
- Niche ETFs, such as those that use various options strategies or inverse ETFs, can also be used for hedging or trading purposes.
- ETFs also offer liquidity as they are traded like equities listed on an exchange.
- Depending on the jurisdiction, ETFs could also provide tax efficiency and enable investors to reinvest dividends
Investors have different investment objectives as well as risk/return profiles. Therefore, the suitability of an ETF depends on numerous factors that are mostly unique for each individual. Discussing personal investment objectives with a financial planner could be helpful in better appreciating whether an ETF is a good investment for you.
ETFs pros and cons
ETFs enable investors to invest in different asset classes (such as equities, fixed income, currencies, commodities, cryptocurrencies or derivatives), sectors (such as the 11 S&P sectors), global exposure and niche themes.
Diversification can help decrease the overall portfolio volatility, for example, by reducing company-specific risks.
- Flexibility in Trading
ETFs are listed on stock exchanges. Therefore, retail investors can buy and sell them easily and quickly during trading hours. It is possible to give different order types (such as limit or stop). Investors can start investing with relatively small capital appropriate for their circumstances.
Many ETFs also have options available. Thus experienced investors or traders can use them for different strategies, such as hedging. Finally, some brokers might enable investors to buy on margin or sell short.
- Cost-Effectiveness—for the most part
Especially for long-term investors in index-based, large, and liquid ETFs, yearly operating expenses, as well as other trading costs (such as bid/ask spread or brokerage costs), are not high. Therefore, in the long run, investors can increase their absolute returns.
However, we should remind readers that actively managed, leveraged, and inverse ETFs typically have higher fees than passive funds.
Many ETFs, especially index-based ones, have clear investment objectives, tracking a given benchmark’s returns. In the US, ETFs update data daily, including portfolio holdings, which individuals can access easily. So for retail investors, there are no surprises as to what they are buying.
However, there are also non-transparent ETFs, a category approved by the SEC in 2019. Such funds are not required to publish their portfolios daily.
- Potential Tax Efficiency
Tax consequences of investments depend on several factors, such as jurisdiction, asset class, holding period, and an investor’s citizenship or residency. However, in the US, ETFs are regarded as more tax-efficient than mutual funds. Interested readers should ask a tax professional that could affect their circumstances.
- Market Volatility Might Lead to Less Liquidity
ETFs are typically liquid products. However, sometimes market volatility goes up sharply, similar to what we experienced in the early days of COVID-19. On such occasions, investors might have a more difficult time trading a given product.
- Tracking Error
An ETF typically trades close to its NAV (net asset value). But sometimes, there are differences between the price of the benchmark index tracked and the NAV. This difference is the tracking error.
In general, minor tracking errors do not impact long-term returns. However, they might be a point of concern for short-term traders.
- Settlement Date
Different jurisdictions are likely to have different settlement dates or when transactions become final. For example, in the US, for most securities, the settlement date is T+2.
Therefore, investors need to understand whether they have enough settled cash in their brokerage accounts to cover the cost of an ETF trade.
- ETF Returns Will Mirror the Returns of the Index
When investors buy index ETFs, their returns will be similar to the index’s returns, minus the ETF’s annual expenses and trading costs. Put another way, it cannot outperform or underperform the index.
However, in the case of actively-managed ETFs, returns will depend on various factors. Therefore, potential investors need to understand what type of ETF they are buying to avoid unintended surprises during their investment horizon.
How many types of ETFs are there?
Different types of ETFs that can be used by long-term investors, speculators, passive-income seekers, or those searching for hedging products include:
Index ETFs: Replicate the returns of a specific index.
Inverse ETFs: Also known as short or bear ETFs. They are designed to generate daily returns opposite the return of an underlying index.
Leveraged ETFs: Designed to generate leveraged daily returns, such as 2X (twice) or 3X (three times) the return of an underlying index. A leveraged fund can also be an inverse ETF, in which case the fund would aim to deliver daily returns of -2X or -3X.
Equity (or Stock) ETFs: Give access to a basket of stocks that might be classified by industry, theme, or geography. In addition, stock ETFs might invest in a specific market capitalization (cap), such as “small-cap,” “mid-cap,” or “large-cap.” Finally, stock ETFs might be set up to achieve a specific investment objective, such as “growth,” “income,” or “low volatility.”
Bond (or Fixed Income) ETFs: Specifically invest in bonds or other fixed-income securities, like government bonds, municipal or investment-grade corporate bonds.
Commodity ETFs: Can track either the spot price or the futures-based price of soft or hard commodities. Soft commodities include coffee, cocoa, corn, soybean, sugar, wheat, and livestock. Hard commodities include gold, silver, other precious and rare metals, and oil. Most investors regard commodities as a hedge against inflation.
Currency ETFs: Enable investors to invest in currencies or foreign exchange (forex). Among the most popular currency ETFs are those that track the US dollar, euro, Canadian dollar, British pound, and Japanese yen.
Industry ETFs: Typically based on 11 sectors as defined by the Global Industry Classification Standard (GICS).
International or Country ETFs: Invest in a specific geography or country. Making it easier for investors to include international stocks in their portfolios.
Actively-managed ETFs: Unlike passive funds, active ETFs do not track an index or benchmark. Instead, fund managers make active and frequent investment decisions to generate high returns. As a result, such ETFs tend to have higher annual operating expenses.