Here is a short FAQ on ETFs to provide a brief tutorial to help investors not familiar with ETFs learn some basic facts. I hope you find it educational!
What is an ETF?
An exchanged-traded fund (ETF) is a pooled investment vehicle (similar to a mutual fund) whose shares can be bought and sold throughout the day on a stock exchange. The biggest difference between mutual funds and ETFs is that ETFs provide real-time pricing and liquidity. Most mutual funds can only be bought and sold after the market has been closed and the Net-Asset Value (NAV) has been calculated based on the closing prices of the funds holdings. Most ETFs are passive, which means they track an index (like the S&P 500), however, there are plenty of other options in the ETF universe that track commodities, Large-Cap stocks, Small-Cap stocks, and so forth.
Why Have ETFs Increased in Popularity?
- ETFs trade on the exchanges just like a stock.
Most mutual funds are priced at the end of the day and do not allow intra-day trading. An ETF can be bought just like a stock. Some ETFs even trade 24 hours now! It is also possible to sell short an ETF (unlike a mutual fund), so many traders like to use ETFs that track indexes to hedge their portfolio against a market downturn, or even make an outright “bet” on lower prices. A lot of ETFs have underlying options as well. Lastly, many discount brokers are now offering commission-free trades on a selected group of ETFs.
- Transparency
Most mutual funds only report their holdings once a quarter as required by law. ETF holdings are very transparent, you always know what the underlying instruments in the ETF you are considering are.
- Diversification and Ease
The exposure to a basket of financial instruments is very appealing to most investors. If you want exposure to the Corporate bond market or the oil drilling stocks, you can easily find an ETF that tracks the group. You can also gain exposure to many markets that would be much more difficult as a U.S. based retail investor. There are over 50 ETFs and counting, that track world market indexes, allowing you to gain exposure to a market that you would not be able to normally invest in.
- Financial Incentives
ETFs are generally more tax-efficient than actively managed funds. They also tend to have lower fees and less turnover which are hidden costs to your bottom line as an investor.
Why should I choose an ETF over a mutual fund?
Generally ETFs have certain advantages over mutual funds including:
- Real-Time Pricing & Liquidity
- Lower Management Fees and Transaction Costs
- More Flexibility and a Wider Range of Investment Options.
- Unlike mutual funds, most ETFs are required to disclose their holdings each day.
You think the next great market is Peru? You can buy an ETF that tracks the Peruvian stock market. Gold is over-valued versus palladium? You can sell short (selling first, with the idea that the price will be lower in the future) the gold ETF and buy the palladium ETF.
How many ETFs are there?
There are thousands of ETFs trading on U.S. Listed exchanges. Building an ETF portfolio from scratch is a daunting process. By eliminating the ETFs available to you from your discount broker with poor liquidity, we reduce the field of screenable ETFs to a much more manageable level so that we can produce optimal portfolios.
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