ETF stands for exchange-traded funds. It is a type of investment instrument that is traded on the stock exchange. An ETF tracks a particular asset and attempts to replicate its performance. In addition, let's dive deeper into how to invest in ETFs.
Buying or selling an ETF is similar to buying and selling a stock. Most online broker platforms and brokerages have a section for ETFs. As long as you have a trading account, you can invest/trade ETFs.
Let us explore ETFs in more detail, look at the advantages and disadvantages they offer, and how the strategies for trading ETFs differ from strategies for investing in ETFs.
Table of Contents
What are ETFs: An Introduction
Exchange-traded funds are exactly what the name suggests. They are invested in regulated exchanges like the NYSE, the LSE, or any other major exchanges in the world.
And yes, they are funds, just like mutual funds. Money is pooled in from various investors and then deployed to hold a particular asset. The asset could be a basket of stocks, an index, a commodity, derivatives, and fixed-income securities.
ETFs are open-ended funds and there are usually no limitations on the number of individuals who can invest.
Nowadays, you can pretty much find an ETF for any niche or industry vertical that you can think of. ETFs became available sometime in the 1990s. In their early days, ETFs weren’t as popular as they are now today.
You may be amazed to learn that the total assets under management for ETFs have crossed $8 trillion in recent times. That is how much money retailer investors, institutions, pension funds, and a variety of agencies and entities have invested in ETFs.
Because a wide variety of ETFs with a variety of themes/philosophies are available, the problem is that of plenty. One has to research an ETF and whether it fits the investment/trading purpose and accordingly choose an ETF.
How to Invest in ETFs: Advantages and Disadvantages
ETFs have become popular as they offer several advantages to investors:
Price discovery: ETFs are traded on stock exchanges in real time. As long as the market is operating during its regular hours, one can trade ETFs.
Bear in mind, this is very different from a mutual fund whose price gets updated only once at the end of the day. So, from a price discovery perspective, ETFs have an edge.
Diversification: ETFs allow investors to buy a basket of securities rather than a handful. The diversification of ETFs allows for an efficient way to diversify one’s portfolio without having to choose financial assets individually.
Let’s take a look at a general example; consider how much money it would take to buy every one of the S&P 500 stocks, one of the biggest indexes on the financial market.
Given there are, specifically, 503 companies in the S&P500 index, one can imagine how much capital and time it would require to buy shares in such a developed index.
You can buy an ETF tracking that very index at a fraction of the capital.
Diversification can equally pose risks as well, as it can be more difficult to manage over time.
Variety: There are plenty of themes available to invest in through ETFs. You can find thematic ETFs that track niche trends like cloud computing, artificial intelligence, millennial consumers, mergers and acquisitions arbitrage, etc.
ETFs also have some disadvantages that investors and traders need to be aware of:
Settlement Duration: As ETFs are traded on the stock exchange, the actual delivery of the traded units is subject to the settlement time of the stock exchange. It can often be T+2 days (2 days after the trade) before the quantity of traded units reflects on your account.
Tracking Error: One of the most important metrics to look at when evaluating ETFs is the tracking error. Every ETF attempts to follow an underlying asset, index, or portfolio of some sort. If that underlying asset gets rebalanced, the ETF also has to rebalance to stay updated. This usually happens with a slight lag.
ETFs may also hold a certain portion of their pooled funds as cash. So, there is usually a slight difference in the performance of the underlying asset and that of the ETF. This difference is the tracking error.
Volatility: While being available for trade throughout market hours is a good thing, it also leads to higher volatility. If the market is volatile on certain days, the ETF prices also tend to follow suit.
The Problem of Plenty: Too many ETFs means it can get overwhelming for someone to actually try and select a handful of ETFs to invest in. There are multiple ETFs just tracking the S&P 500, let alone trying to figure out thematic ETFs.
What are ETFs in Investing?
ETF investing involves transacting ETFs for a relatively longer duration. The idea behind ETF investing is to gradually compound capital rather than exploit a shorter-term opportunity.
ETF investing can also be shorter-term, but that won’t be anything like intra-day or a week. When an investor buys an ETF, it is usually for long-term significant growth opportunities.
Some investors like to systematically build ETF positions. This can be done through systematic investment plans where a fixed amount is invested into ETFs every few days, weeks, or months. The idea is to take market timing out of the equation and invest over a longer period of time.
What are ETFs: Conclusion
We hope that you now have a basic understanding of what ETFs are, where they are traded, and how they are different from mutual funds.
In this article, we also covered the advantages and disadvantages of ETFs and talked about the variety of ETFs on offer. We touched upon how big the ETF world has become in terms of the assets under management and how to invest in ETFs.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.