Exchange-traded funds (ETFs) are a popular investment option for those seeking to build a diversified yet cost-effective portfolio. ETFs are investment vehicles that track the performance of a specific market index, such as the Straits Times Index (STI) or the S&P 500. Similar to individual stocks, ETFs can be traded on a stock exchange during regular market hours.
Whether you are an individual investor or an experienced financial professional, ETFs offer a convenient and potent investment tool to help you achieve your financial goals. Their ability to provide broad market exposure while minimizing costs makes them an attractive choice for a wide range of investors.
Why are ETFs popular?
ETFs have gained widespread popularity among investors for several key reasons:
- Cost efficiency: ETFs are generally passive investments that aim to track the performance of an underlying market index. This passive approach allows them to keep costs low, with ongoing charges typically ranging from 0.07% to 0.65% or more for actively managed funds. The difference in fees can have a significant impact on investment returns over the long term.
- Diversification: ETFs provide investors with exposure to a diverse range of assets, including stocks, bonds, and other securities, allowing them to build well-diversified portfolios more easily. Investors can access a wide variety of market sectors and asset classes through a single ETF transaction.
- Accessibility and liquidity: Traded on stock exchanges, ETFs can be bought and sold throughout the trading day, just like individual stocks. This flexibility allows investors to quickly adjust their portfolio allocations as needed.
- Broader market exposure: Many ETFs track broad market indices, such as the FTSE 100 or S&P 500, providing investors with cost-effective exposure to the overall performance of these markets. This passive approach has been shown to outperform the average actively managed fund over the long term, once fees are taken into account.
While passive investing may seem less exciting than actively managed funds, the combination of low costs, diversification, and market-matching performance makes ETFs a popular and compelling investment option for a wide range of investors.
ETF trading and investing
Exchange-traded funds (ETFs) come in two main types: physical and synthetic.
Physical ETFs invest directly in the underlying assets they aim to track. For example, a FTSE 100 tracker ETF would invest in the stocks of the companies that make up the FTSE 100 index, while a gold ETF would hold physical gold bullion in a vault. It’s important to note that when you invest in an ETF, you are purchasing shares of the ETF itself, not the individual securities or assets it holds.
Synthetic ETFs, on the other hand, are more complex. They use “swaps” – a type of derivative instrument typically provided by investment banks. These swaps are designed to deliver the same returns as the index or underlying investment the ETF is tracking. Synthetic ETFs allow investors to gain exposure to markets that may be difficult to access directly, such as certain commodities or stock markets with foreign investment restrictions.
Synthetic ETFs carry a higher level of risk due to “counterparty risk” – the possibility that the investment bank providing the swap cannot fulfill its obligations. To mitigate this risk, swap providers are usually required to post collateral. Physical ETFs are generally simpler to understand and less vulnerable to hidden risks, making them more suitable for individual investors.
Noteworthy that like any investment, the value of an ETF can rise or fall, and you may end up with less than your original investment. Proper research and diversification are crucial when investing in ETFs, whether physical or synthetic.
How to invest in ETFs
ETFs trade like individual stocks, so they can be easily added to an investment portfolio. One of the most tax-efficient ways to hold ETFs is within an investment ISA account. An investment ISA allows your ETF investments to grow free from capital gains tax and income tax.
Tax rules are subject to change over time, and the tax benefits of holding ETFs in an ISA will depend on your individual financial circumstances. You may want to consult a financial advisor to understand the best approach for your specific situation.
Type of ETFs
Passive ETFs
Passive ETFs aim to replicate the performance of a broader index, such as the S&P 500 or a more targeted sector or trend. They passively track the index without active management.
Actively managed ETFs
Actively managed ETFs do not track an index. Instead, portfolio managers make decisions about which securities to include in the fund. This can provide potential benefits over passive ETFs, but also tends to come with higher fees.
Bond ETFs
Bond ETFs provide regular income to investors by holding a portfolio of underlying bonds, which can include government, corporate, and municipal bonds. Unlike the individual bonds, bond ETFs do not have a maturity date.
Stock ETFs
Stock ETFs hold a basket of stocks that track a single industry or sector, like automotive or foreign stocks. This provides diversified exposure to that sector, including both high performers and new entrants with growth potential. Stock ETFs have lower fees than traditional stock mutual funds.
Sector/Industry ETFs
These ETFs focus on a specific sector or industry, such as the energy or technology sectors. They hold stocks of companies operating in that particular area of the economy.
Commodity ETFs
Commodity ETFs invest in physical commodities like crude oil or gold. This can help diversify a portfolio and provide a hedge against market downturns, at a lower cost than directly owning the commodities.
Currency ETFs
Currency ETFs track the performance of currency pairs, allowing investors to speculate on currency price movements or hedge against forex volatility.
Bitcoin ETFs
Bitcoin ETFs provide exposure to bitcoin’s price movements by either holding the underlying bitcoin (spot ETFs) or using bitcoin futures contracts (futures ETFs).
Inverse ETFs
Inverse ETFs use derivatives to profit from declines in the underlying investments, essentially allowing investors to “short” the market.
Leveraged ETFs
Leveraged ETFs seek to provide multiples (e.g. 2x or 3x) of the returns of their underlying investments, using debt and derivatives to amplify the gains and losses.
Popular ETFs
S&P 500 ETFs
The SPDR S&P 500 ETF (SPY) is the oldest and most well-known ETF, tracking the broad S&P 500 index.
Small-cap ETFs
The iShares Russell 2000 ETF (IWM) provides exposure to the small-cap Russell 2000 index.
Tech-focused ETFs
The Invesco QQQ ETF (QQQ), often called “the Cubes”, tracks the Nasdaq 100 index which is heavily weighted toward technology stocks.
Blue Chip ETFs
The SPDR Dow Jones Industrial Average ETF (DIA), nicknamed “the Diamonds”, holds the 30 stocks in the Dow Jones Industrial Average.
Country/Regional ETFs
Country-specific ETFs provide exposure to the equities of a particular foreign market, such as China (MCHI), Brazil (EWZ), Japan (EWJ). Broader regional ETFs cover emerging markets (EEM) and developed markets (EFA).
Dividends and taxes
In addition to potential capital gains as stock prices rise, ETF investors can benefit from the dividends paid by the underlying companies. ETF shareholders are entitled to a proportionate share of any dividends or interest earned by the fund.
ETFs tend to be more tax-efficient than traditional mutual funds. When an investor wants to sell their ETF shares, the transaction occurs on an exchange rather than directly with the fund itself. This helps avoid the tax liability that can arise when a mutual fund has to redeem shares.
The creation and redemption process for ETF shares also contributes to their tax efficiency. When an authorized participant (AP) creates new ETF shares by exchanging a basket of the underlying securities, this transaction is generally not a taxable event. Similarly, when an AP redeems ETF shares for the underlying securities, it does not trigger a taxable distribution for other ETF shareholders.
Net asset value
The net asset value (NAV) of an ETF represents the total value of the fund’s assets divided by the number of outstanding shares. ETF shares may trade on the exchange at a price that is slightly above or below the fund’s NAV, reflecting market supply and demand. However, the creation and redemption process helps keep the ETF’s market price closely aligned with its underlying NAV.
The tax-efficient structure of ETFs, combined with their ability to pay out dividends, can make them a compelling investment option for many investors.
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FAQs
What was the first ETF?
The SPDR S&P 500 ETF (SPY), launched by State Street Global Advisors in 1993, is often considered the first modern exchange-traded fund. However, there were some precursor products, such as Index Participation Units listed on the Toronto Stock Exchange in 1990, that tracked market indexes prior to the introduction of SPY.
How do ETFs compare to managed funds?
ETFs and managed funds (mutual funds) both pool investor money to invest in a basket of securities. The key differences are:
Management style: Mutual funds are actively managed by a fund manager, while ETFs are typically passively managed to track a specific index.
Trading: Mutual fund shares can only be bought and sold at the end of each trading day, while ETF shares can be traded throughout the day like stocks.
Costs: ETFs generally have lower expense ratios than actively managed mutual funds.
How is an ETF different from an index fund?
An index fund is a type of mutual fund that tracks a specific market index, such as the S&P 500. An index ETF is constructed similarly, but has some key advantages:
Costs: Index ETFs tend to have lower expense ratios than index mutual funds.
Liquidity: ETF shares can be traded intraday, while mutual fund shares only transact at the end of the trading day.
Do ETFs provide diversity?
Most ETFs provide instant diversification by holding a basket of securities. However, some ETFs may be more concentrated, either in the number of holdings or the weightings of their largest positions. Investors should review an ETF’s prospectus to understand its level of diversification.
Final word
ETFs offer investors a convenient and cost-effective way to gain exposure to a broad range of securities. The combination of diversification, trading flexibility, and low costs makes ETFs a popular investment vehicle for many investors. However, there are still some expenses, such as trading commissions and the fund’s expense ratio, that should be considered.
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