Exchange-traded funds (ETFs) have grown rapidly since their invention in the early 1990s, in large part because of their low associated cost, exchange access, holdings transparency, and range of asset classes (from traditional investments to alternative assets) available. They are basket of securities one can buy or sell on a stock exchange or through a brokerage firm.
They are organised under the same regulation as mutual funds; however, they are different when it comes trading and tax efficiency.
ETFs function differently from mutual funds in the method of share creation and redemption. Mutual fund shares must be purchased or sold at the end of the day from a broker or fund manager at the closing net asset value (NAV) of the fund’s holdings, in a cash-for-shares or shares-for-cash swap. In contrast, an ETF trades intraday, or during the trading day, just like a stock. ETF shares are created or redeemed in kind, in a shares-for-shares swap. Net asset value (NAV) is the value of a fund's asset less the value of its liabilities per unit.
How ETFs work
Just like how a company stock is bought and sold during the day when the stock exchange is opened, ETFs are traded in a similar fashion. An ETF has its own ticker symbol and the intraday price data can easily be accessible during the course of the trading day.
However, unlike companies’ stocks, ETFs can change daily because of the continuous creation of new shares and redemption of existing shares. These helps to keep the market price of ETFs in line with their underlying securities.
Types of ETFs-not an exhaustive list
Market ETFs: Designed to track a particular index like the S&P 500, FTSE 100, DAX 30, CAC 40.
Bond ETFs: Designed to provide exposure to virtually every type of bond available; government, corporate, municipal (state and local), international, high-yield etc.
Sector and industry ETFs: Track a particular industry, such as pharmaceuticals, banking, oil and gas sector or high technology.
Commodity ETFs: Invest in commodity, such as gold, oil, or agricultural products like corn.
Style ETFs: Track an investment style or market capitalization focus, such as large-cap value or small-cap growth.
Inverse ETFs: Designed to profit from a decline in the underlying market or index by shorting stocks. Shorting is selling stock, expecting a decline in value, and repurchasing at a lower price.
Currency ETFs: Invests in currencies such as USD, EUR etc.
Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing.
Advantages of ETFs
If you believe the market is moving higher and you want to take advantage of the trend, an ETF can be bought early in the trading day. Do note that the market can move higher or lower by as much as 1% or more on some days. This presents both opportunity and risk. If you are unsure, talk to your advisor.
Low cost: ETFs are known for their low expense ratios, which typically range between 0.10% and 0.25%. Some can be higher if they are less liquid. Because ETFs are passively-managed, the operating costs are dramatically reduced because there is no need for research or analysis, as with actively-managed mutual funds.
Diversification: ETFs are diversified investments because they can provide exposure to many securities, such as stocks or bonds, with the purchase of just one fund. Diversification can reduce risk by spreading the market risk across multiple securities or asset types, rather than just one.
Trading flexibility: ETFs trade intra-day, like stocks. This can be an advantage if you are able to take advantage of price movements that occur during the day. Since ETFs trade like stocks, shares can be bought or sold during the day. This flexibility enables investors to place market orders, such as stop-loss-order, which can be set by the investor to sell to minimise losses.
Niche trading: ETFs can be used to get access to niche areas of the market that are not typically covered by mutual funds. They may cover sub sectors like artificial intelligence and robotics.
Disadvantages of ETFs
Trading cost: ETFs trade like stocks, hence investors may be required to pay a commission. However, do note that some ETFs can be bought or sold free of commission, trading costs can be higher if you as an investor make frequent trades. Even if you only make monthly purchases, as in a dollar-cost averaging strategy, small commissions can add up to make ETFs an expensive investment, compared to a no-load, no transaction fee mutual fund.
Buying high and selling low: ETFs have two prices, namely a bid and an ask. Be aware of the spread between the price you will pay for shares (ask) and the price a share could be sold for (bid). Make sure you know what an ETF’s current intraday value is as well as the market price of the shares before you buy.
Management fee: Not all ETFs are low cost. Make sure you carefully check the expense ratio of the specific ETF you are interested in. Prospective buyers should look carefully at the expense ratio of the specific ETF they are interested in. You may find the ETF of your choice is quite expensive relative to a traditional market index fund.
Should you choose ETF or Mutual Fund?
Some investors like to use a combination of ETFs and mutual funds to build a diversified portfolio. They may use mutual funds for active management and ETFs for tracking certain benchmark indexes. No matter which type of funds you use, be sure to build a portfolio that is suitable for your investment goals, risk tolerance and constraints. Speak to your advisor if unsure.