Exchange-Traded Funds, usually known as ETFs, have gained in popularity over the last couple of decades. They are closely associated with investing passively in the stock market. But they can serve other purposes as well. Let us discuss what an ETF is.
Content
- What is exactly an Exchange-Traded Fund?
- What can we invest in with an ETF?
- Advantages of investing in an ETF
- Conclusion
What is exactly an Exchange-Traded Fund?
ETFs were first introduced in North America in the early 1990s. Its growth since then has been astronomical. By the end of 2019, there were over 4 trillion dollars invested in ETFs globally.
As its name indicates, ETFs are investment funds traded on an exchange. They combine features of both funds and stocks.
They resemble a fund in that they tend to invest in a basket of financial instruments (for example, US stocks), while being traded on an exchange as stocks are, meaning we can buy and sell at any time as long as the exchange on which they trade is open.
If we wanted to invest in a traditional investment fund, we would need to contact an asset management company, tell them how much we want to invest and transfer that amount of money. Once the money is with the asset manager, it will be invested. By the same token, if we want to get our money out, we would need to tell the asset manager, who will have to sell some of the assets in the fund and later on transfer those proceeds to us.
By contrast, an ETF allows us to invest or disinvest at any time. We just need to put in a buy or sell order with our broker. And that order will get executed the same way it would if we were trading a stock.
For example, we can invest in an ETF tracking the most important stock market index in the US, the S&P 500. Doing so is as easy as putting in a buy order with our broker. As soon as the order has been executed, our money will be invested in the most important companies in the United States. We will have the same immediateness we have with a stock, but with the diversification of a fund.
An importhing thing to highlight about ETFs is that the number of shares outstanding can change on a daily basis, unlike with stocks where the number of shares rarely changes.
This is because new ETF shares, also called units, can be created or destroyed at any time. If there is a lot of interest and investors are buying heavily, brokers will create new ETF shares and use those proceeds to buy the underlying assets in which the ETF is supposed to be invested. For example, the companies in the S&P 500 index.
Similarly, if there is a lot of sell pressure, ETF shares will be destroyed. Brokers will sell the underlying assets of the ETF, like S&P 500 stocks, and use those funds to pay the sellers of the ETF shares.
What can we invest in with an ETF?
Even though they are famous for being an excellent vehicle in which to passively invest in stock market indices, ETFs can be more versatile than that. Remember that an ETF is simply a fund that will use our money to invest in other assets. Hence it can invest in things other than just stocks.
In the next section, we will discuss other investment options that are made possible by ETFs. The list is by no means exhaustive.
1) Stock market index ETF
This is the most popular type of ETF. It simply tracks the performance of a stock market index by replicating its composition, which means that it will invest in those stocks that are part of the index in the same proportion as the index.
Some examples of stock market indices that are often tracked by ETFs include the US S&P 500, the German DAX or the Japanese Nikkei. Other popular indices include those that cover entire regions, such as the European Stoxx 600, or the entire world, such as the MSCI World, MSCI Emerging Markets, or MSCI All World Country Index.
Additionally, ETFs give us the option to invest in a basket of stocks with similar characteristics. For example, we can invest in high-dividend paying stocks, the energy sector exclusively, or even small-cap companies.
There are also indices for those types of investments, such as the Eurostoxx Select Dividend 30 index.
2) Bond ETF
Bonds, which are debt instruments issued by governments and corporations, are the largest financial market in the world, larger than the stock market.
There are multiple bond indices designed to track the performance of the bond market. And bond indices vary significantly from one another. There are very broad bond indices. Bond indices that focus on certain sectors, such as either government or corporate bonds. And índices that solely track bonds with short maturities. The possibilities are almost endless.
And these índices, just like stock market indices, are also used to construct passive investment vehicles, like ETFs, for those who want to invest in the stock market without having to purchase individual bonds.
If you would like to know why it can be beneficial to add bonds to your portfolio, check out the following post:
Investing in Bonds – Reasons and Risks
3) Commodity ETF
Commodities are simply natural resources that can trade on an exchange. The most popular commodity is oil. But there are many others, including gold, silver, aluminum, wheat or coffee.
Commodity indices are used to create a basket of commodities and track their performance. These commodity índices are then used to créate Exchange-traded funds that allow investors to invest in the commodities market in a diversified way.
They can be a great addition to your portfolio, especially if you want to shield it against the negative effects of inflation. For more information about why we should consider commodities in a diversified portfolio, I suggest you read the following post:
Top Reasons for Investing in Commodities
4) Precious metals ETF
Although considered commodities, precious metals can be treated as a separate asset class because they can act as a safe haven. This is because we can concentrate a relatively significant amount of wealth in something that can be held in our hands and takes up relatively little space.
Consequently, for investors who would like to put some of their capital in gold or silver, multiple ETF providers offer the option to invest in a gold or silver ETF. They simply hold those precious metals in a vault, charge you a fee for it, and in exchange you can buy and sell easily at any time, without having to keep the physical metal yourself.
If you are wondering whether you should invest in physical gold or a gold ETF, I suggest you read the following comparison I made:
Investing in a Gold ETF – Advantages & Disadvantages
Advantages of investing in an ETF
Let us analyze the main advantages of investing in an ETF:
1) Low cost
Exchange-traded funds tend to be low cost. This is one of the reasons that explain their success. Management fees are usually moderate or low. In fact, the larger the ETF, the lower fees tend to be.
It is possible to find stock market ETFs that will charge us less than 0.1% annually in terms of management fees.
It is true that trading fees apply as well, because ETFs trade on exchanges. However, trading fees are usually minimal for most investors that do not want to continuously buy and sell their investments.
2) Diversification and almost unlimited options
ETFs are by themselves diversified investment vehicles. They give us the option to invest in hundreds or even thousands of companies by simply buying one instrument.
Additionally, we can combine ETFs of different asset classes, such as stocks, bonds, commodities and precious metals, and build a super diversified portfolio.
If you are interested in building a diversified portfolio with a handful of ETFs, check out this post:
Build a Diversified Portfolio with ETF
3) Tax efficient
Another advantage of investing in ETFs is that they can be more tax efficient than buying the underlying stocks or bonds in the ETF. This is because it lowers our need to buy and sell assets, which may trigger tax consequences. On top of that, they can be more tax efficient in how dividend payments are treated.
When it comes to stock and bond ETFs, it is worth checking if they distribute or accumulate dividend and interest payments, as well as redemptions.
Distributing ETFs will pay us on a regular basis, which may trigger a tax event. Accumulating ETFs reinvest all cash flows received from their underlying securities, making it possible for us to avoid the payment of taxes until we sell that ETF.
Conclusion
As we just saw, exchange-traded funds are about a lot more than just investing in stock market indices.
It is true that standard stock ETFs are a fantastic way to invest in stocks in a diversified way. Why buy the 500 companies in the S&P 500 when we can just buy a Vanguard fund ETF?
But this logic can be taken further. ETFs are a great tool to add diversification to our portfolios. They make it very easy to invest in commodities and bonds. And even to implement more complex investment strategies.
Therefore, I encourage you to learn about the different asset classes available and how they react to certain macroeconomic and financial events.
If you would like to do it on my blog, you can check out the following post:
Guide to Asset Classes
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