Exchange-traded funds or ETFs are a type of fund that owns the underlying assets (stocks, commodities, bonds, etc.) and divides ownership of those assets into shares. ETFs are bought and sold like shares on a stock exchange, but unlike conventional shares, they are not businesses, but rather investment funds that can invest in a number of things. ETFs are one of the fastest growing categories of investment products in the world with over $USD 3 trillion in funds held and have been around since the late 1980s. They are popular among both institutional and individual investors as they offer a wide array of benefits for investors.
Breaking down ETFs
The value of the ETF on a stock exchange generally represents the value of all different underlying investments held by that ETF. Most ETFs invest in only one asset class, such as shares or commodities, and typically aim to provide the returns of a specific index (e.g. NASDAQ100), asset classes (e.g. gold or commodities) or provide exposure to a certain investment strategy (e.g. high income, emerging markets, etc.)
The actual investment structure varies between countries, but typically shareholders do not directly own or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets. Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.
• Diversification – When buying ETFs, an investor is essentially gaining exposure to all the investments held in that ETF through a single trade. ETF’s track a broader range of assets or even attempt to mirror the returns of a country or group of countries.
• Lower Fees – Because ETFs are intended to track the performance of a particular index or asset class, there is no need to hire expensive fund managers or stock pickers. This keeps management costs down for the investor compared to other managed funds.
• Transparency – Because ETFs are traded on a stock exchange, investors can clearly see the price when they are bought and sold. In addition, the ETF’s specific investments are readily available to investors on a daily basis.
• Tax Efficient – ETFs are more tax efficient compared to mutual funds as capital gains are paid on the sale of the security, which is determined by the investor. Mutual funds, on the other hand, are required to distribute capital gains to shareholders whenever the fund manager sells security for profit. Therefore, through ETFs, the investor can have better control over when they pay capital gains tax.
• Simplicity – ETFs are easy to buy and sell as they trade during the day on a stock exchange. Because of this, there is no minimum investment and no paperwork to complete when an investor wants to buy or sell.
Risks to consider
• Trading Costs– Although ETFs are a lower cost option when compared with mutual funds, you must still pay commission whenever you buy or sell. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment’s performance. If your strategy is to frequently invest small amounts, there may be lower-cost alternatives by investing directly in a no-load fund.
• Wide Bid-Ask Spreads – The Bid-Ask spread is the depth in the market and determines the buy and sell prices of the security. Therefore, if the specific ETF has low volume, meaning there is not much market interest surrounding the security, the bid-ask spread may widen as there are not many market participants. This means you may be buying the high price of the spread and selling at the low price of the spread, thus limiting your investment performance.
• Investment Risks– The primary risks of investing in ETFs are related to the investment risks associated in the strategy or assets that the ETF provides exposure to. For example, if you invest in an ETF that tracks the performance of the Australian Stock Exchange (ASX) and there is an event that happens domestically which causes the entire overall domestic market to take a hit, the performance of your ETF investment will align directly.
How to Invest
Investing into ETFs may sound like a complicated process as they are different to common stocks in their structure. However, at Monex, we try to make this as simple as possible for our clients so that they can easily diversify their portfolios and grow their wealth.
Popular ETFs include those that track the performance of certain indexes. For example, the SPDR S&P 500 ETF (NYSE: SPY) tracks the performance of the S&P 500, an index based on the market capitalisation of the 500 largest companies listed on the U.S. stock exchanges. Purchasing this ETF will mean that the performance of the trade is linked directly with the performance of the U.S. stock market. Another popular ETF strategy may be sector related, where you can gain exposure to multiple companies in a specific sector or type of strategy. A popular example of this is the Betashares Global Sustainability ETF (ASX: ETHI), which invest in the their top 100 with strict environmental and ethical guidelines. Such an ETF provides exposure to large companies who are global leaders, and relate to sectors around renewable energy, healthcare, healthy food companies and more.
Whether you are looking to gain exposure to various markets, sectors, or commodities, ETFs provide a great solution as they are cost-effective, tax efficient and simple to use. At Monex, we strive to deliver the best solutions to our clients through our trading platform. We make it easier for you to gain exposure to all the ETF’s across our 12 markets so that you can diversify your portfolio and grow your wealth. Providing access to multiple markets also allows for much greater depth when looking for the most suitable ETF that meets your investment philosophy and goals.
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