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The investing arena can often feel like the Wild West. Whether it’s stocks and shares, mergers and acquisitions, or exchange-traded funds (ETFs) — the industry is jam-packed with confusing terminology.
Nevertheless, it is important that you have a firm understanding of what an ETF is, especially because they are arguably one of the most utilized and comprehensive asset classes in the financial spectrum.
As such, we’ve created the complete beginner’s guide to ETFs. Within it, we’ll discuss everything that you need to know. This will include how they work, the type of assets that they track, the fees that you will need to consider, and more.
What is an ETF?
In its most basic form, an exchange-traded funded, or simply ‘ETF’, is an investment vehicle that tracks an asset, or group of assets. In doing so, it allows investors to speculate on the price of an asset that would otherwise be difficult to trade.
Let’s take gold for example. Ordinarily, if you wanted to invest money in gold, you would be required to purchase physical jewelry or bars, and subsequently store it in a safe environment. Moreover, attempting to sell it at a later date would not only be a logistical nightmare but hugely expensive.
By instead investing in an ETF, you have the option of speculating on the value of gold at the click of a button, with no requirement to actually purchase or store the underlying asset.
It is important to note that ETFs are not just reserved for commodities like gold, silver and oil. On the contrary, there are literally thousands of ETFs in existence, covering virtually everything that has real-world value.
Whether it’s real estate, stock market indices, interest rates, foreign currencies or legal marijuana, you can be all-but-certain that an ETF exists.
A further advantage that ETFs offer over traditional assets like stocks and shares is that they allow you to ‘go short’ with ease. In other words, if you believe that the value of an asset is likely to go down, you can facilitate your speculation via an ETF.
So now that you have an idea of what an ETF actually is, in the next section of our guide we are going to find out how they work.
How do ETFs Work?
Before you invest in an ETF, it is important that you have a firm grasp of how they work. First and foremost, by investing in an ETF, you do not actually own the underlying asset.
For example, if you purchased an ETF is the US real estate market, you would not have a legal right over the properties that make up the ETF. Instead, ETFs are launched merely to track the price movement of the respective asset, or group of assets.
Nevertheless, from the perspective of the investor, this doesn’t really matter. You see, if you were to invest in a crude oil ETF, it is likely that you would be doing so because you felt that the value of oil was likely to go up or down, and thus, you’d hope to make a profit.
The fact that you don’t have physical access to the oil is neither here nor there, not least because ETFs operate in a highly stringent regulatory arena.
How are ETFs Valued
In terms of how the ETF tracks the price of assets, this is usually based on the Net Asset Value (NAV) of the underlying assets. Let’s say for example you purchase an ETF in the NASDAQ-100 Index.
For those unaware, this particular index is tasked with tracking the price movement of the 100 largest US companies listed on the NASDAQ stock exchange. In doing so, you have the chance to invest in 100 companies at the click of a button, as opposed to placing 100 individual trades.
In order to provide a single price, the ETF will track the real-time share price movements of the 100 US companies it is tasked with tracking. However, this isn’t as simple as taking the current share price of each of the 100 companies, as some companies will have a much larger market capitalization in comparison to others.
Think along with the likes of Apple, Facebook and Google.
With this in mind, the ETF is likely to implement a weighting system. Without getting too technical, the ETF will give greater weight to companies that have a higher market capitalization, with the view of demonstrating a much more accurate reflection of the wider index.
Ultimately, as the value of the underlying assets goes up and down, as will the price of the ETF.
Benefits of ETFs
ETFs offer an array of benefits compared to investing in individual stocks or mutual funds. Here are the most relevant benefits you should know about.
Traditionally, investors are charged a commission when buying and selling securities, like ETFs and stocks. Luckily, a revolution in the online broker stage has brought those commissions down or even eliminated them altogether. Brokers like Robinhood and Webull currently offer zero-commission trading for stocks and ETFs.
Mutual funds, on the other hand, can typically include fees when buying and selling. This is one of the main reasons why ETFs are far superior than Mutual Funds from a cost standpoint for long-term investors.
Unlike stocks, ETFs and Mutual Funds charge a management fee. This fee is charged by the financial institutions to actively or passively manage the fund. Management fees for ETFs are generally speaking low (0.5% a year), whereas Mutual fund fees are a bit higher (0.65% a year).
ETFs trade similar to stocks, on an intraday basis. This feature allows ETFs to be substantially more liquid than Mutual Funds, which only trade once a day.
Unlike stocks which liquidity is dependent on how it has traded historically, the liquidity of ETFs is independent of how it has traded in the past. ETF liquidity is calculated based on how liquid the underlying assets are.
Having said that, ETF’s are as liquid or illiquid as the underlying assets are.
Similar to Mutual Funds, ETFs provide diversification to your portfolio. When investors buy shares of an ETF, they are basically getting exposure to a basket of various securities, from stocks and commodities to bonds and futures.
Investors use ETFs to build portfolios and to spread risk. For instance, instead of buying 500 stocks to track the S&P 500, you can easily buy one share of SPY.
Unlike Mutual Funds, ETF providers publish the holdings of the fund so investors get to see what assets they are holding. Mutual funds on the other end are only required to disclose the holdings information once every quarter. This makes ETFs more transparent and attractive to investors compared to Mutual Funds.
As mentioned above, ETF’s trade just like stocks. You have the ability to trade ETFs on an intraday basis. This also means that investors have the ability to short sell ETFs and buy options.
Finally, just like stocks, you don’t have to pay capital gains taxes on ETFs until your positions are sold (some exceptions apply). This is certainly a major advantage of ETFs compared to Mutual Funds which do distribute capital gains to investors from time to time.
Today, there are currently over 6,900 worldwide. Not all ETFs are created equal and they come in different flavors.
These are ETFs highly managed, just like mutual funds. Portfolio managers continuously assess which securities buy or sell.
These ETFs are typically designed to track a particular index or benchmark. For example, the SPY, which tracks the S&P500.
Equity ETFs invest in stocks. There are many types of equity ETFs and the performance varies depending on the region, industry, sector, theme, etc.
There are physically backed or future based commodity ETFs. These are good options when an investor wants exposure to oil or gold for example.
Fixed Income ETFs
These ETFs heavily allocate bonds rather than stocks. The performance will also vary depending on the geography
Some investors may choose to have exposure to a specific sub-sector rather than having exposure to a specific market or region. Thematic ETFs have been developed to provide exposure to a specific “theme”.
New and popular thematic ETFs include blockchain, marijuana, esports, robotics, cloud services, cybersecurity and more.
Who Offers ETFs?
There is often a misconception that ETFs are offered by the same institutions behind traditional stock exchanges like the NYSE or NASDAQ. However, this couldn’t be further from the truth.
On the contrary, ETFs are provided by traditional financial institutions, such as the likes of Vanguard, Fidelity, and BlackRock (iShares). These institutions often have trillions of dollars in assets under management, and as noted earlier, are heavily regulated.
Now, although we noted that by investing in ETFs, you do not actually own the underlying asset, this isn’t the case for the institutions that facilitate the ETF.
In order to ensure that your money is backed by real-world assets, institutions will typically purchase the respective assets that constitute the ETF, with the view of tracking the underlying prices as accurately as possible.
For example, let’s say that you invest in an ETF that tracks the Russell 2000, which is an index that tracks the share price movement of 2000 small-cap US companies. Large ETF providers will often purchase the company shares themselves, as they have the financial and logistical means to do so with ease.
Other asset classes, such as oil, are not as straightforward. As it wouldn’t make any sense for the ETF provider to physically purchase billions of dollars worth of oil barrels, they will instead invest in options, futures and forward contracts.
Nevertheless, irrespective of how the ETF provider chooses to inject investor funds into the underlying asset, the price of the ETF itself is executed on a second-by-second basis, during standard market trading hours.
So now that you know that ETFs are provided by well-known financial institutions, in the next section of our guide we are going to explore how you can invest in one.
What Fees are Involved?
As we have discussed extensively in this guide thus far, ETFs are provided by established financial institutions. In return for facilitating and managing the respective ETF index, these institutions will charge a fee. This is where things get a bit confusing.
Traditionally speaking, ETFs charge something called an ‘Expense Ratio’. This is expressed as a percentage of the amount of money you have invested in the ETF and is charged on an annual basis.
According to the Wall Street Journal, the average Expense Ratio charged on ETFs is 0.44%. As such, a $10,000 investment would cost you a mere $44 per year. In the grand scheme of things, this offers excellent value, especially when you consider the ease at which you can invest in complex financial vehicles.
However, the good news is that due to the somewhat oversaturation of the online broker space, it is now possible to invest in ETFs without paying any trading fees. This is the case with the previously mentioned Robinhood and Webull.
Investors will still have to pay the usual management fee (expense ratio) to the ETF provider, typically under 0.5%, but they will be saving on commissions or annual maintenance fees traditional brokers used to charge in the past.
Note: The spread is the difference between the ‘Bid Price’ and ‘Ask Price’. The smaller the spread, the more cost-effective it is for the investor.
Do ETFs pay Dividends?
Whether or not an ETF pays dividends will depend entirely on the specific asset or group of assets that the respective ETF is tracking. For example, if the ETF is tracking a group of shares listed on the NASDAQ, it is likely that the ETF will pay dividends as and when they are distributed, if applicable.
However, this will only be the case if the ETF provider actually owns and holds the underlying shares. If they don’t, they won’t be eligible for dividends, and thus, you won’t receive them.
On the other hand, if you are investing in a non-stock-based ETF, such as oil, gold or real estate, then naturally you won’t have the opportunity to earn dividends.
Ultimately, if earning dividends is your primary investment goal, then ETFs might not be the best way to go about it. Instead, you might be best to purchase the stocks and shares directly.
How do You Invest in ETFs?
Without attempting to confuse you further, it is important to note that in most cases, you will need to invest in an ETF via a third-party broker, as opposed to doing it directly with the ETF provider. The reason for this is that ETF providers do not have the required framework to facilitate small buy and sell orders, as they are best suited for institutional-grade money.
With that being said, investing in an ETF via an online broker is now super easy. In fact, competition is extremely fierce, meaning that the costs of investing are now at record lows.
First and foremost, you will need to go and open an account with your chosen broker. If you’re a first time user, then you might want to consider the likes of Robinhood or Webull. These online brokers not only offer user-friendly platforms but they also offer zero commission trading for stocks and ETFs.
Most importantly, both Robinhood and Webull platforms facilitate the buying and selling of more than 145 individual ETFs. As such, you can choose to speculate on the price going up and down.
Once you head over to your chosen online broker to open an account, you will initially need to provide some personal information. This is industry-standard and will require information pertaining to your name, address, nationality, date of birth, and social security number (if applicable).
Before you can invest in your first ETF, you will also need to verify your identity. Standard anti-money laundering (AML) laws dictate that you will need to upload a copy of your government-issued ID, and you might also need to supply proof of your current address.
As soon as you’ve done this, you can then proceed to deposit some funds. If you decide to open an account with either Webull or Robinhood, you don’t need to maintain a minimum balance, and you can start investing in ETFs with as little as $1.
Once you’re all set-up with a fully funded account, you can then navigate through the ETFs that the broker offers. At this point, you will need to determine how much you want to stake, and perhaps, more importantly, whether you want to buy or sell the ETF.
If you buy the ETF, this means that you think the price will rise. If you sell the ETF, you are speculating that its value will go down.
When you’ve finalized the trade, you can sell your ETF at any time, as long as it’s during market hours.
If you’ve read our guide from start to finish, then you should now have a firm understanding of what an ETF is, how they work, and most importantly, whether or not they meet your investment goals.
Overall, ETFs are a highly useful financial vehicle, not least because they allow you to speculate on assets that would otherwise be challenging to invest in. Whether its a real estate market, commodities like oil and gold, or an entire stock market index, ETFs can facilitate this at the click of a button.
The great news for you as an investor is that it is now possible to invest in ETFs on a fee-free basis, meaning you are no longer required to pay an annual Expense Ratio.
Ricardo is an entrepreneur, investor and personal finance nerd who enjoys spending time with his family and friends, travelling and helping others achieve their financial goals. Ricardo has been quoted as a personal finance expert in several online publications including Healthline, Bankrate, GOBankingRates, MSN Money, Yahoo Finance, U.S. News & World Report, Forbes and USA Today.