Understanding Exchange Traded Funds (ETFs)

Sep 4, 2020

What is an ETF?

An ETF (exchange-traded fund) is an extremely popular financial trading instrument that is essentially a basket of securities, for example, stocks from large public companies that are traded on the stock exchange. ETFs are not limited to a single industry; however – they can contain various types of assets such as commodities, bonds, ETFs, etc.

An ETF is marketable security, which means they have an associated price that makes it easy to buy and sell. ETF share prices tend to fluctuate during the day as the asset is bought and sold continuously. Due to this, ETFs are more liquid than mutual funds. Mutual funds are not traded on an exchange, for example, but only once a day when markets close.
ETFs are great for diversifying your portfolio since they are funds that hold multiple underlying assets. ETF can hold numerous assets across different industries, or they can be restricted to a certain industry, such as tech, for example. ETF can also be restricted to certain countries.

Usually, ETFs are tracked by an underlying index, such as the S&P 500. The highest weighing companies in the index are Apple Inc., Microsoft, Amazon.com, Alphabet Inc., Facebook, Johnson & Johnson, Berkshire Hathaway, Visa Inc., Procter & Gamble, and JPMorgan Chase. ETFs are listed on the stock exchange, just like normal stocks.
Traders can exchange ETF either through traditional broker-dealers or online brokers.

What are some types of ETFs?

There are multiple types of ETF available to investing that are used for different purposes such as income generation, hedging, speculating on price fluctuations, and managing risk:

  • Currency ETFs: Foreign currencies such as the EUR, USD, or Canadian dollar.
  • Bond ETFs: Corporate bonds, government bonds, municipal bonds.
  • Commodity ETFs: Crude oil, gold, and silver.
  • Industry ETFs: Those can be ETFs from different industries such as the financial industry, tech, oil, gas, etc.
  • Inverse ETFs: Traders attempt to earn on such ETFs by shorting (selling) stocks when they decline. When value declines, stocks can be repurchased for a better lower price. Inverse ETFs are actually not considered true ETFs but are instead called ETNs (exchange-traded notes). ETNs are bonds, but trade like stocks and are usually financed by banks.

ETF portfolios can be actively-managed, which essentially means that portfolio managers buy and sell shares of different companies. Normally these kinds of funds will have a higher expense ratio versus passively managed ones, which is why investors need to understand the costs involved as well as their returns.
There are also indexed-stock ETFs that offer investors diversified index funds that allow them to buy as little as one share, sell short and buy on margin with no minimum deposit requirements. Some ETFs will concentrate heavily on one industry, while others will focus on groups.

What are some advantages and disadvantages of ETFs?

There are reasons why traders like ETFs and opt to add them to their portfolio when possible. One of the main reasons would cost. ETFs are cheaper to buy rather than individual shares and require the trader to only execute a single transaction at a time, which leads to lower commission and fewer trades done by investors. Trading costs can pile up as brokers will usually charge a commission for every trade you execute; therefore, reducing the number of trades executed can highly reduce costs.

Below are some other benefits of trading with ETFs:

  • Access to different shares across different industries
  • Lower costs
  • Ability to manage risks due to portfolio diversification
  • Ability to access both targeted and non-target industries

Yet, despite all the positives, ETF does have some negatives. Unfortunately, they may occasionally lack liquidity, which impedes transactions. In addition to this, targeted or single-industry ETFs defeat the purpose of portfolio diversification.

ETF Creation and Redemption

ETF supply is regulated through a dedicated mechanism, ‘creation and redemption.’ Both of these processes involve APs (authorized participants), who are specialized investors.
In order to use additional shares, the AP will buy shares from an index that’s tracked by a fund and trade them for new ETF shares. The AP will sell ETF shares to an ETF sponsor from which they will make a profit. This process is known as ‘creation.’
On the other hand, another process involves the AP buying shares from an ETF on an open market. The shares will then be sold back to an ETF sponsor in exchange for individual stock shares. This process is called ‘redemption.’

What are some examples of ETFs?

Some of the most popular examples of ETFs available for trading are:

  • SPDR Dow Jones Industrial Average (DIA): A popular ETF representing the 30 stocks of the Dow Jones Industrial Average.
  • SPDR S&P 500 (SPY): One of the oldest and best-known ETF tracks the S&P 500 Index.
  • The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV): A physically-backed ETF that holds gold and silver.
  • Natural Gas (UNG) and Crude Oil (USO): These represent markets that include.
  • Oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH) – industry-specific ETF.

Despite the fact that investors can earn dividends on fluctuating stock prices, they also benefit from dividends. Dividends are allocated by companies to investors who hold their stock and the good thing is that investors who buy ETFs are entitled to the profits that companies generate.

There are over 5000 ETFs traded across the world, and amongst the largest one of them is BlackRock iShares, which has almost 40% market share. ETF first came about in 1993 in the USA and was eventually adopted by Europe in 1999. S&P 500 was the first ETF to be traded on the American Stock Exchange.