Exchange-traded funds are one of the most important and valuable products created for individual investors in recent years. ETFs offer many benefits and, if used wisely, are an excellent vehicle to achieve an investor’s investment goals.
Briefly, an ETF is a basket of securities that you can buy or sell through a brokerage firm on a stock exchange. ETFs are offered on virtually every conceivable asset class from traditional investments to so-called alternative assets like commodities or currencies. In addition, innovative ETF structures allow investors to short markets, to gain leverage, and to avoid short-term capital gains taxes.
After a couple of false starts, ETFs began in earnest in 1993 with the product commonly known by its ticker symbol, SPY, or "Spiders," which became the highest volume ETF in history. There are now estimated to be over $1 trillion invested in ETFs and nearly 1,000 ETF products traded on U.S. stock exchanges.
Types of ETFs
- Market ETFs: Designed to track a particular index like the S&P 500 or NASDAQ
- Bond ETFs: Designed to provide exposure to virtually every type of bond available; U.S. Treasury, corporate, municipal, international, high-yield and several more
- Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology
- Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn
- Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
- Foreign market ETFs: Designed to track non-U.S. markets, such as Japan's Nikkei Index or Hong Kong's Hang Seng index
- Inverse ETFs: Designed to profit from a decline in the underlying market or index
- Actively managed ETFs: Designed to outperform an index, unlike most ETFs, which are designed to track an index
- Exchange-traded notes: In essence, debt securities backed by the creditworthiness of the issuing bank; created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes
- 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
How ETFs work
An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day.
Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.
Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.
Advantages of ETFs
The appeal of ETFs to individual investors is:
- Buy and sell any time of the day: Mutual funds, in contrast, settle after the market close
- Lower fees: There is no sales load, however, brokerage commissions do apply
- More tax efficient: Investors have better control over when they pay capital gains tax
- Trading transactions: Because they are traded like stocks, investors can place a variety of types of orders (limit orders, stop-loss orders, buy on margin) which are not possible with mutual funds
Disadvantages of ETFs
While superior in many respects, ETFs do have drawbacks, including:
- Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund
- Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread
- Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies
- Settlement dates: ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale are not technically available to reinvest for 2 days.
Once you have determined your investment goals, ETFs can be utilized to gain exposure to virtually any market in the world or any industry sector. You can invest your assets in a conventional fashion using stock index and bond ETFs, and adjust the allocation in accordance with changes in your risk tolerance and goals. You can add alternative assets, such as gold, commodities, or emerging stock markets. You can move in and out of markets quickly, hoping to catch shorter term swings, much like a hedge fund. The point is, ETFs give you the flexibility to be any kind of investor that you want to be.
What the future holds
Innovation has been the hallmark of the ETF industry since its beginnings less than 25 years ago. Undoubtedly, there will be new and more unusual ETFs introduced in the years to come. While innovation is a net positive for investors, it’s important to realize that not all ETFs are created equal. You should investigate carefully before investing in any ETF, carefully considering all factors to ensure that the ETF you choose is the best vehicle to achieve your investment goals.