What is an ETF?
March 19, 2021
One of the most popular investment vehicles available these days are ETFs, or Exchange Traded Funds. First established in 1993, ETFs now attract several trillion dollars in investment every year.
Investors like ETFs because they’re a simple, flexible, cost-effective way to participate in the stock market while also building and maintaining a broad, diversified portfolio.
So, what exactly is an ETF?
An ETF is a fund that contains a basket of assets. Each fund may contain hundreds or even thousands of different assets within it. Some contain stocks in companies, some are linked to stock market indices or specific market sectors, while others hold a selection of bonds, commodities, or even currencies. There are also ETFs that are made up of a mix of different kinds of asset classes.
Every ETF has its own stock ticker symbol, and shares in the fund are traded on exchanges just like stocks, with their price rising and falling throughout the day based on demand. In this respect they are different from mutual funds, which aren’t traded at all throughout the day, and have a single daily price that’s set at the end of each trading session.
Why are ETFs so popular?
One of the main reason’s ETFs have become so popular is they make it easy and affordable for individual investors to build a balanced, diversified portfolio. Buying all the constituent parts of an ETF would not only cost a great deal but would also force an investor to pay a large number of commissions and fees to a broker to execute those purchases. With an ETF, however, that entire basket of holdings is available in a single fund, meaning it only takes one purchase to get a piece of everything within.
Also, due to their relative simplicity, the fees associated with ETFs tend to be lower than other types of investment products. In fact, many brokers don’t charge any commission at all on ETFs.
Another benefit of ETFs has to do with tax implications. Compared to mutual funds, for instance, ETFs tend to generate much lower amounts of capital gains, diminishing the tax hit for investors.
Finally, ETFs offer transparency to investors by disclosing each individual fund’s holdings on a daily basis. Again, this is in contrast to mutual funds, where the holdings are typically only disclosed on a monthly or quarterly basis.
Is there a catch?
ETFs do have a few disadvantages, and fees are often the main one. Make sure you’re aware of any fees and commissions associated with buying and selling an individual ETF before you choose to invest in it. If the costs are too high for you, shop around for a similar, cheaper ETF or consider investing in a no-load mutual fund, which won’t cost you anything in fees or charges.
Another potential drawback is buying an ETF that doesn’t trade very much, making it difficult to sell when you want to cash out. Similarly, some ETFs that don’t attract significant investment may cease trading entirely and close. In such instances, investors are forced to sell, perhaps ahead of schedule and possibly at a loss.
What to remember
It’s important for investors to remember that not all ETFs are the same. Those with a narrower focus may be more susceptible to risk and volatility, while those that are more actively managed tend to charge higher fees and commissions. Make sure to investigate carefully before investing in a specific ETF and consider how each new purchase fits into your overall investment goals.