Exploring The World Of Exchange Traded Funds
The financial markets are made up of several components that work together in harmony. These components form the overall market ecosystem and give people the opportunity to trade and invest in the stock market while capitalizing on market trends. One such asset class that has always been an investor favorite are exchange-traded funds.
An Exchange-traded fund, commonly known as an ETF, is a basket of securities that can hold assets like stocks, commodities, bonds, and more. These funds are traded on stock exchanges and can be purchased and sold just like a regular stock. Investing in ETFs is a great way to diversify your portfolio and minimize the overall risk on your capital. Exchange traded funds also give you the opportunity to invest in almost any sector or industry that you desire.
First developed in the 1990s, ETFs were created so that investors could gain access to passive, indexed funds. However, since their inception, the exchange-traded fund market has grown tremendously and today almost every investor and trader uses them. Nowadays, ETFs represent a vast range of asset classes like broad market indices, niche sectors, industries, alternative asset classes, and more. According to the Statista Research Department, the assets managed by ETFs globally amounted to approximately 7.74 trillion U.S. dollars in 2020.
This represents a significant amount of overall global investors’ wealth as ETFs have been an attractive investment option in recent years, where, people have started preferring ETFs over stocks and other asset classes as an investment option. In this article, we will dive deep into the world of exchange-traded funds and explore everything to give you a clearer and better picture of this asset class. So, let’s get started!
What is Asset Allocation?
Asset allocation is a way of investing your capital into different asset classes according to your goal, risk profile, and investment horizon. The objective of allocating your capital into different asset classes is to minimize the overall risk of your portfolio and take advantage of cross-sector investing. This ensures that your portfolio grows at a steady and consistent pace while minimizing the overall risk. Asset allocation involves separating your capital for investments in different asset classes. The three main types of asset classes are stocks, bonds, and cash or marketable securities.
Other alternative asset classes are also available such as real estate or commodities, cryptocurrencies and more. People also invest in hedge funds and start-ups as an alternative investment. When it comes to investing and asset allocation, there are a plethora of options available.
However, this all depends on several factors that will decide which asset class is the best investment option for you. The main factors that affect your investment decisions and help in asset allocation are your time horizon, investment goal, and risk profile.
The end goal of allocating your capital in different assets is to ensure that if one of your investments suffers a loss then the other assets can make up and balance that drawdown. It ensures no single investment can destroy your entire capital and helps in reducing your portfolio’s overall risk.
What is an Exchange Traded Fund?
An exchange-traded fund or ETF is a type of investment fund that holds various assets that can range from stocks, bonds, commodities, and even track an index or market sector. ETFs are traded on stock exchanges and can be bought or sold like a regular stock in market trading hours. The price of ETFs keeps on fluctuating throughout the day and thus, offers ample liquidity.
This ensures that investors and traders can enter and exit their investments and positions whenever they desire. Exchange-traded funds allow several investors to pool their capital together and then invest it in any asset class that the particular ETF focuses on. Investing in an ETF is a great way for an investor to diversify their portfolio and gain exposure to multiple assets via a single investment method.
An ETF can be structured to track anything from the price of a single underlying asset to multiple assets combined. For example, the SPDR S&P 500 ETF is an ETF that tracks the S&P 500 index. So, if the S&P 500 remains green throughout an entire trading session, then the price of the SPDR S&P 500 ETF will also remain green, thus benefiting from the movement of the underlying index.
ETFs can be made of any asset class like stocks, bonds, commodities, and more. The benefit of investing in an ETF is that an individual investor does not need to worry about diversifying their investments as the ETF will usually deploy its capital into several types of asset classes, thus, diversifying the entire portfolio and reducing the overall risk on investment.
Several ETFs are also made up of mixed asset classes instead of focusing on a single asset or sector, allowing broad diversification. The best part about investing in ETFs is that they can be easily bought or sold just like any regular stock. ETFs also offer lower expense ratios and have lower brokerage commissions when compared to purchasing stocks individually.
Exchange Traded Funds in a Nutshell
- Exchange-Traded Funds are a basket of securities that trade on a stock exchange, just like a stock.
- ETFs were first developed in the 1990s as a way to provide access to passive, indexed funds to individual investors.
- ETFs can be structured to contain all types of asset classes, like stocks, bonds, commodities, and market indexes.
- The price of an ETF fluctuates throughout the entire trading day as it is bought and sold by market participants, unlike mutual funds where the price is updated once a day after the market closes.
- ETFs offer better diversification than investing in individual stocks and have lower expense ratios.
Types of ETFs
There are several different types of exchange-traded funds that an investor can invest in. This gives an investor the freedom to invest in the asset class or market sector they desire. Some of the most common ETF types are the following –
Stock ETFs hold a portfolio or basket of stocks that can range from various different market sectors or an individual market sector. These ETFs invest in several different stocks, giving their portfolio the advantage of diversification and cross-sector investing. Stock ETFs range from mixed stock ETFs to sector-specific ETFs, for example; Cannabis ETFs. So, a cannabis ETF will hold a portfolio of several cannabis stocks, and this entire investment fund is traded on a stock exchange and can be bought or sold throughout the trading day.
Just as the name implies, bond ETFs are funds that invest in bonds or other fixed-income securities. These ETFs may focus on a particular type of bond or they may include various types of bonds in their portfolio, diversifying their investments and creating a well-balanced fund.
Index ETFs are funds that are based on an underlying market index. These ETFs mimic a specific market index, for example; the S&P 500 index or the Dow Jones Industrial Average index. Any changes in the index will affect these ETFs, therefore, giving investors the ability to invest in broad market indexes and capitalize on market trends.
Commodity ETFs invest in commodities such as agricultural goods, precious metals, natural resources, and more. Commodity ETFs are generally sector-specific. For example, a Gold ETF will be based on its underlying asset: Gold. Therefore, any changes in the price of Gold will affect the gold ETF. Commodity ETFs like a gold ETF can also include companies that are involved in the gold mining sector.
Currency ETFs are funds that are invested in a single currency or a basket of various currencies. These ETFs can be used by investors who wish to gain exposure to the foreign exchange market without directly trading the futures or forex market. These ETFs usually track the most popular currencies like the U.S. dollar, Euro, British Pound, Canadian dollar, Japanese yen, and more.
Leveraged & Inverse Exchange Traded Funds
Now, after going through the most common types of exchange-traded funds, let us explore what leveraged and inverse ETFs are. These ETFs are unlike other ETFs and have a different way of functioning. Let’s explore them in detail –
Leveraged exchange-traded funds are ETFs that use financial derivatives and debt to amplify the returns that they generate of an underlying index. Leveraged ETFs are usually available for majority of the market indexes. While a traditional ETF typically tracks the securities in the underlying index on a one-to-one basis, a leveraged ETF on the other hand may target a ratio like 2:1 or even 3:1.
Leveraged ETFs usually use derivatives like futures contracts and options contract to magnify their exposure to a particular market index. Leveraged ETFs are a great way to generate huge wealth as their exposure is much higher than traditional ETFs. However, these are high-risk investments as they can cause huge losses if the market moves in the opposite direction.
This amplifies the returns tremendously, but the downside is that the losses are also amplified. Leverage is a double-edged sword, which, if used properly can generate huge wealth, but if mismanaged, it can lead to huge wealth destruction.
Inverse exchange-traded funds are funds that are constructed in a way to profit and make money when their underlying asset declines in value. So, an inverse ETF makes money when the security it invests in declines in value and turns bearish. These ETFs profits from bearish markets and lose money when the markets are bullish and positive. Investing in inverse ETFs is similar to holding short positions, where the individual stands to make a profit if the security declines in value.
An inverse ETF is also called a “Bear ETF” or “Short ETF”. These funds are created using financial derivatives like futures contracts and options contracts, which allow the fund to profit when the index or security turns bearish and declines in value. Adding inverse ETFs to your portfolio can allow you to profit even when the entire market may be declining.
Why Invest in Exchange Traded Funds?
ETFs offer several benefits to investors such as low expense rations, broad diversification, lower brokerage charges when compared to stocks individually, increased market exposure, and much more. Investing in ETFs also reduces the burden of researching and analyzing every stock individually, as all one needs to do is track and study the performance of the particular ETF that they wish to invest in. Investing in ETFs also ensures that your capital is well diversified within various sectors and helps in reducing the overall risk to your capital.
Along with all these benefits, ETFs have significantly lower expense ratios when compared to mutual funds and can be bought and sold easily, as there is high liquidity. So, let’s go over some of the advantages that exchange-traded funds offer.
Advantages of Exchange Traded Funds
Diversification & Risk Management
Investing in ETFs gives an investor the advantage of diversification in their portfolio. The ETF will deploy its capital into several different types of asset classes and ensure the capital is well-diversified, thus, minimizing the overall risk on investment. This is great for an investor as they do not have to constantly monitor and reorganize their portfolio, as the ETF will automatically diversify their investments, reducing and managing risk in an optimal manner.
Can Be Easily Bought or Sold
Another advantage of investing in ETFs is the fact that they can be easily bought or sold during market hours just like any other stock. This is unlike mutual funds, where one cannot purchase and sell the asset multiple times during a single trading session.
Lower Fees & Expense Ratio
ETFs offer a lower expense ratio and have lower fees, this ensures that you as an investor get the most out of your investment. The fees an ETF charges is way less than that of a mutual fund, and these costs can add up to become a significant amount over the long run, eating up your profits. Therefore, ETFs offer better value to an investor when it comes to fees and other expenses.
Limited Capital Gains Tax
Another advantage that exchanges traded funds offer are fewer deductions in capital gains tax when compared to actively managed mutual funds. ETFs can be more tax-efficient when compared to mutual funds, and thus, help an investor get the most out of their invested capital.
Disadvantages of Exchange Traded Funds
While some ETFs are actively traded, a lot of them aren’t, and that can cause low liquidity. This might force an investor to hold on to their positions as they might not get an opportunity to exit their investments due to low volumes. So, before adding an ETF to your portfolio, always check and ensure that it has good liquidity.
Lower Dividend Yields
While there are some ETFs that pay dividends, they still might not be as high as owning a basket of high dividend-paying stocks. While ETFs offer lower risk and benefits of broad diversification, the dividend yields of individual stocks can come out to be much higher than of ETFs.
Leveraged ETFs Can Be Risky
Leveraged ETFs can prove to be a high-risk investment, as oftentimes, markets may move in the opposite direction than anticipated, and leverage can amplify the losses, resulting in huge wealth destruction.
Now, with all this information, we hope that you have understood what exchange-traded funds are and how they work. ETFs, in general, are a great investment option for investors as they minimize risk and help diversify your investments in an optimal manner. With several different types and categories of ETFs available, you can choose and invest in the ETF that you like.
However, investments in the stock market are subject to market risk, and careful analysis and research are crucial to success in the world of finance. So, we hope that this article provided you with helpful information and knowledge. If you would like to see more such interesting content on the financial markets, then do check out Jeremy’s YouTube channel “Financial Education”. Happy investing!