What is an Exchange-traded Fund (ETF)?

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by Adedamola Bada · 8 min read
What is an Exchange-traded Fund (ETF)?
Photo: Marco Verch / Flickr

An exchange-traded fund (ETF) is a fund that facilitates straightforward entry to a large number of different securities such as stock and bonds. Learn how it works, how to operate an ETF and check today’s best ETFs in this guide.

An exchange-traded fund (ETF) is a fund that facilitates straightforward entry to a large number of different securities such as stock and bonds. Shares that are bought in an ETF are generally more liquid than traditional shares, come with lessened fees, and is lucid terms of functions.

When an individual invests in an ETF, he/she consistently receives a percentage gain on the profits made by the fund. The size of this percentage profit solely depends on the number of shares the individual holds in the ETF fund. ETF shares can be traded on stock exchanges and experience frequent variations in price every day, subject to the demand and supply.

ETFs are similar to mutual funds in terms of the purchase of the securities you want. The financial instrument bought is then targeted at tracking a stock index. To ascertain the total value of an ETF, the value of the individual securities owned by the fund needs to be calculated.

How Exchange-traded Funds Work

An ETF can be described as a hybrid of a mutual fund and a stock. Mutual funds operate by gathering an inflow of cash from numerous individuals to buy financial instruments they deem to be bullish in the near future. The cash pulled from the various sources is then handled by a PM or portfolio manager. Payments to the mutual fund are then made by its investors. In recent times, cryptocurrency ETFs for digital currency investors are also springing up.

An investor looking to buy into a mutual fund can only do so at the close of the day’s market. The investor then pays a price that is the same as the mutual fund’s share. On the other hand, an investor who wants to purchase shares of an exchange-traded fund can buy when the market is open. ETF investors usually purchase at a price that’s close to the ETF’s share.

Sometimes, new ETF shares could be added which would affect the total supply of the shares held by investors. Mutual funds, on the other hand, produce shares based on the positive difference between the money flowing into the fund and the money flowing out of it.

Only big financial institutions in the market can ensure the addition of shares to an ETF. A single unit of ETF shares varies from 25,000 to 200,000 in quantity. These big market players can also redeem units for the financial instruments. It is particularly because of this redemption for financial instruments that shares held by an ETF are traded near to their value. This basically signifies that ETF investors would never be short-changed when buying or selling their ETF shares.

 Why Investors Like ETFs

Compared to mutual funds, ETFs possess a lot of benefits. A few of the core benefits are mentioned below.

  1. Lessened Fees

Typically, exchange-traded funds have lower expense ratios than mutual funds. An expense ratio means the percentage of your portfolio that would be collected by the fund to offset its fees. When a fund quotes its expense ratio as 2%, it means that 2% would be taken out of your investment annually as payment for costs. Several funds don’t record the cost deduction in the statement. It simply appears as a reduction in the asset value of the investor.

There are exchange-traded funds on the New York Stock Exchange that have expense ratios as low as 0.04%. The same goes for ETFs traded on NASDAQ. The low expense ratios are part of what makes exchange-traded funds an attractive option to investors.

  1. The fluidity of sales and purchases

Investors view the allowance of ETF shares being traded at any time during market hours a viable option. In comparison, mutual funds can only be traded at the daily close of the stock market. A lot of investors also like the fact that ETF shares can be traded like stocks; sold at high prices and bought at the price dip, and the purchase of those shares using leveraged trading (borrowing margin on trade to increase yield).

The option of getting increased margin by the use of leverage is one that many investors like due to the possibility of a really profitable ROI.

  1. Lucidity

Each day, an ETF provides investors with information about the financial instruments being held by the fund. This way, you get complete transparency on the securities you’re holding through the ETF shares. In comparison, mutual funds only reveal their holdings every quarter.

  1. Reduced Taxes

ETFs generally pay less in tax than mutual funds. This is largely due to the fact that ETF portfolio managers make much fewer trades on stocks, unlike mutual funds. In fact, ETFs mostly trade a stock when a part of the index the ETF is tracking changes. This could occur when a company liquidates or is merged with another firm.

How to Successfully Buy an Exchange-traded Fund

It’s quite easy for investors to purchase ETFs. You can purchase an ETF at the same place stocks are bought – a brokerage. You can make use of online brokers that charge low commissions on trades to do this. However, you need to make certain you have locked in on the various ETFs you want to buy before choosing a broker. Not all brokers offer a wide range of ETFs.

To make good decisions on the ETFs you want to buy, you have to determine what the index tracks, the age of the fund, and the financial instruments held by the fund. ETFs that track indexes like the S&P 500 have been around for a long period of time. Some ETFs track new, unfathomable indexes and could be quite volatile. When considering investing in the long-term, you should stay clear of ETFs that track these new indexes.

You also have to bother yourself about the expense ratio of the ETF. Since the expense ratio determines the percentage of your investment that would be removed as costs for the fund each year, you’d have to get a fund that offers low expense ratios. Keep in mind that the expense ratio doesn’t cover the commissions on the purchase and sale of ETF shares.

The average expense ratio of ETFs is listed at 0.44%. Newer ETFs that track new indexes usually have a higher expense ratio, so you’ll have to watch out for that. On average, an index fund carries an expense ratio of 0.74%.

You also have to check how much tax you’d be paying with the ETF. The organization of an ETF facilitates lower tax commitments. Newer ETFs that track new indexes often over-trade leading to higher capital gains tax. Some ETFs that are taxed higher than the average rate, however, could be funds that hold assets like precious metals which are taxed at a highly increased rate, at almost 100% more than the usual rates.

The Best ETFs in the World Today

  1. Vanguard S&P 500 ETF

The Vanguard exchange-traded fund stems from the world’s most popular mutual fund, Vanguard. The S&P 500 index is tracked by the Vanguard ETF. It also has an expense ratio that’s way lower than the ETF fund average at 0.04%. Owing to the sole tracking of the S&P 500, all investments made by the ETF are narrowed only to the US. The S&P 500 is considered one of the best ways to measure the health of the US economy and typically give an ROI of about 10% annually.

  1. Fidelity ZERO Total Market Index Fund 

The Fidelity ETF has not been around for a very long while. However, the fund does not charge any fees and has no minimum investment threshold. The ETF is narrowed to stocks traded on the NYSE and NASDAQ, giving it more options for growth than an S&P 500 fund.

  1. iShares Russell 2000 ETF (IWM)

The IWM focuses on the Russell 2000 index, one that tracks the stocks of small companies in the US. The IWM’s expense ratio is pegged at 0.19%. Investors that ignore the volatility of the stocks of smaller companies and feel the stocks have the chance to grow bigger mostly invest in the IWM.

Investing in the exchange-traded fund is a great way to make money consistently on the stock market. An ETF is strikingly similar to a mutual fund in terms of operations, except for a few differences that stand out. ETFs are more transparent than mutual funds, offer lower fees, can be traded at any period during the stock market open and its investors pay lower taxes.

Before investing in an exchange-traded-fund, a potential investor must first consider the age of the ETF, the index the ETF tracks, the expense ratio charged, and the frequency of trades made by the ETF. These decisions would help to choose an ETF best suited to an investor to bring in the highest possible returns.

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