Exchange Traded Mutual Funds ETFs Basics and Benefits

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ETFs offer a convenient way to invest in a diversified portfolio with minimal fees.

ETFs are traded on stock exchanges, just like individual stocks, which allows for easy buying and selling throughout the day.

ETFs hold a basket of securities, such as stocks, bonds, or commodities, and their value is based on the net asset value (NAV) of the underlying securities.

This structure makes ETFs a popular choice for investors who want to gain broad exposure to a particular market or sector.

ETFs typically have lower fees compared to actively managed mutual funds, with an average expense ratio of 0.2% to 0.5%.

This can save investors a significant amount of money over time, especially in larger portfolios.

What Are ETFs?

ETFs are investment funds that hold multiple underlying assets and can be bought and sold on an exchange, much like an individual stock.

They can be structured to track anything from the price of a commodity to a large and diverse collection of stocks.

ETFs can even be designed to track specific investment strategies.

The first ETF in the U.S. was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.

ETFs are available to investors for income generation, speculation, or hedging risk in an investor’s portfolio.

Investment Basics

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To start investing in ETFs, you'll need to open a brokerage account. This can be done through online brokers, traditional broker-dealers, or even robo-advisors like Betterment and Wealthfront.

You can also purchase ETFs in your retirement accounts, making it easy to incorporate them into your long-term investment strategy. Most online investing platforms offer commission-free trading, so you won't have to pay extra fees to buy or sell ETFs.

ETFs are widely available, and you can find them on many online investing platforms, retirement account provider sites, and investing apps like Robinhood.

Investment Basics

ETFs are a type of investment that allows you to trade on various markets, including stocks, bonds, and commodities.

You can buy and sell ETFs through online brokers and traditional broker-dealers, or even through robo-advisors like Betterment and Wealthfront.

Many online platforms offer commission-free trading, which means you won't have to pay fees to buy or sell ETFs.

To find the right ETF, use a screening tool that filters options based on criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.

You can search for ETFs on most online investing platforms, retirement account provider sites, and investing apps like Robinhood.

Once you've created and funded a brokerage account, you can start buying and selling ETFs as you see fit.

Price Stability

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Price stability is a major concern for investors. Purchases and sales of commodities by ETFs can significantly affect the price of such commodities.

The International Monetary Fund has warned that the growing popularity of ETFs may have contributed to equity price appreciation in some emerging economies. This can pose financial stability risks if equity prices were to decline for a protracted period.

ETFs can be used to manipulate market prices, such as in conjunction with short selling. This was a factor in the United States bear market of 2007-2009.

New regulations were put in place following the 2010 flash crash, but they proved inadequate to protect investors. The price of many ETFs appeared to come unhinged from their underlying value during the August 24, 2015, flash crash.

Regulators and investors are still scrutinizing ETFs, with analysts at Morningstar, Inc. pointing out that ETFs are governed by "Depression-era legislation".

The Role of in Asset Allocation

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ETFs are increasingly being used as part of a balanced approach to asset allocation, with European investment professionals declaring that their use of ETFs for tactical allocation is greater than for long-term positions, 53% to 51% respectively.

Over the past few years, the use of ETFs has shifted from a purely passive investment approach to a more tactical one. This is likely due to the growing diversity of ETFs, which now cover a wide range of asset classes and market sub-segments.

Gaining broad market exposure remains the main focus of ETFs for 73% of users, but 52% of respondents also use ETFs to obtain specific sub-segment exposure. This flexibility is especially useful in volatile markets.

Investors can easily adjust their portfolio exposure to a specific style, sector, or factor at a lower cost with ETFs.

Types of ETFs

ETFs come in many forms, each with its own unique characteristics and benefits. There are passive ETFs that aim to replicate the performance of a broader index, such as the S&P 500.

Credit: youtube.com, Index Funds vs ETFs vs Mutual Funds - What's the Difference & Which One You Should Choose?

Actively managed ETFs, on the other hand, have portfolio managers who make decisions about which securities to buy and sell, providing a more hands-on approach. However, they charge higher fees compared to passive ETFs.

Bond ETFs are used to provide regular income to investors, with distribution depending on the performance of underlying bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.

Some popular types of ETFs include commodity ETFs, which invest in commodities like precious metals, agricultural products, or hydrocarbons. Currency ETFs track the performance of currency pairs, allowing investors to speculate on exchange rates or diversify their portfolios.

Here are some examples of ETF types:

  • Passive ETFs: Replicate the performance of a broader index.
  • Actively managed ETFs: Have portfolio managers who make decisions about which securities to buy and sell.
  • Bond ETFs: Provide regular income to investors.
  • Commodity ETFs: Invest in commodities like precious metals, agricultural products, or hydrocarbons.
  • Currency ETFs: Track the performance of currency pairs.

Types

There are many types of ETFs to choose from, each with its own unique characteristics.

Passive ETFs aim to replicate the performance of a broader index, such as the S&P 500.

Actively managed ETFs, on the other hand, have portfolio managers who make decisions about which securities to buy and sell, offering benefits but also charging higher fees.

Credit: youtube.com, Different types of ETFs: which to pick?

Bond ETFs provide regular income to investors, with distribution depending on the performance of underlying bonds.

Industry or sector ETFs track a single industry or sector, like automotive or energy, offering diversified exposure to a single industry.

Commodity ETFs invest in commodities like gold, oil, or silver, and can be used to diversify a portfolio.

Here are some examples of commodity ETFs:

Inverse ETFs, on the other hand, earn gains from stock declines without having to short stocks, using derivatives to short a stock.

Leveraged ETFs seek to return some multiples on the return of the underlying investments, using debt and derivatives to leverage their returns.

Bitcoin ETFs expose investors to bitcoin's price moves in their regular brokerage accounts, purchasing and holding bitcoin as the underlying asset.

Bond

Bond ETFs are a type of exchange-traded fund that invest in bonds.

They generally have much more market liquidity than individual bonds. This means you can easily buy and sell them.

Bond ETFs offer a convenient way to diversify your portfolio by investing in a variety of bonds with just one trade.

Cryptocurrency

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Cryptocurrency ETFs allow investors to invest in or short major cryptocurrencies like Bitcoin and Ethereum, or a basket of different cryptocurrencies. They're issued by companies like Invesco and Deutsche Bank.

Spot crypto ETFs directly invest in cryptocurrencies, tracking their real-time prices. This means their share prices will fluctuate with the prices of the cryptocurrencies they hold.

Future-based crypto ETFs invest in crypto futures contracts, agreements to buy or sell cryptocurrencies at a predetermined price in the future. This can result in different share price trends compared to spot crypto ETFs.

Ethereum is gaining traction in the cryptocurrency market, particularly in ETFs. In fact, Ethereum ETFs have surpassed Bitcoin ETFs in daily inflows, with a record $332.9 million on November 29, 2024.

Ethereum's open interest has reached a historic peak of $24.08 billion, and exchange reserves have increased by 750,000 ETH in one month. This reduced selling pressure and reflects growing institutional interest in Ethereum ETFs.

ETF Structure and Management

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ETFs represent managed "baskets" or "pools" of individual securities, like stocks or bonds, similar to mutual funds and the majority of Exchange Traded Funds (ETFs). This structure allows investors to buy and sell a bundle of assets with a single transaction.

ETFs and mutual funds can be designed to track an index or actively managed to outperform an index. There are different management styles to choose from, including passive and active management.

Passive ETFs and Index Mutual Funds track an index, while Active ETFs and Actively Managed Mutual Funds try to outperform the index. Here's a breakdown of the different management styles:

Similar Structure

ETFs and mutual funds have a similar structure. They represent managed "baskets" or "pools" of individual securities, like stocks or bonds.

One key difference is that mutual funds trade only once a day after the markets close, whereas ETF share prices are determined throughout the day. This allows ETF investors to buy and sell their shares at market value, rather than at the end of the day.

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ETFs hold shares of all the companies on a specific index, such as the MSCI US Investable Market Consumer Staples 25/50 Index. This index includes 104 companies, some of which are familiar consumer brands like Proctor & Gamble, Costco, and Coca-Cola.

Investors buy a share of the ETF, which owns the shares of the underlying companies. This means there is no transfer of ownership, as the ETF itself owns the shares, not the individual investor.

Arbitrage Mechanism

The arbitrage mechanism is a crucial aspect of ETF structure and management. It's what helps keep the share price in line with the net asset value of the underlying assets.

ETF shares are created and redeemed in large blocks, known as creation units, which typically consist of 50,000 shares. This process involves authorized participants (APs) acting as market makers, purchasing and redeeming ETF shares directly from the ETF issuer.

APs provide market liquidity for ETF shares and help ensure their intraday market price approximates the net asset value of the underlying assets. This is done through the creation and redemption of creation units, which are generally in kind.

Credit: youtube.com, Video ETF Arbitrage Animated Explanation

If there's strong investor demand for an ETF, its share price may temporarily rise above its net asset value per share. This creates an incentive for arbitrageurs to purchase additional creation units from the ETF issuer and sell the component ETF shares in the open market.

The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process occurs when there's weak demand for an ETF, causing its shares to trade at a discount from their net asset value.

ETF inflows occur when new shares are created due to increased demand, while ETF outflows happen when shares are converted into the component securities. The effectiveness of the arbitrage mechanism is essential for ETFs to track their net asset value accurately.

Management Styles

ETFs can be designed in different ways to achieve varying investment goals. There are two main styles of management: passive and active.

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Passive management involves tracking an index, which means the fund replicates the performance of a specific stock market index. This approach is often used in ETFs and index mutual funds.

Active management, on the other hand, involves a specific trading strategy to outperform an index. This style is used in actively managed ETFs and mutual funds.

Some actively managed ETFs address the risk of front running by trading only weekly or monthly. This approach helps to keep the manager's trading strategy private.

The largest actively managed ETFs have annual fees ranging from 0.18% to 0.36%. For example, the JPMorgan Ultra-Short Income ETF charges 0.18% in annual fees, while the Pimco Enhanced Short Duration ETF charges 0.36% in annual fees.

Here's a summary of the main management styles:

  • Passive ETFs: Track an index
  • Active ETFs: Execute a specific trading strategy
  • Index Mutual Funds: Track an index
  • Actively Managed Mutual Funds: Execute a specific trading strategy

Frequently Asked Questions

How do you make money with exchange traded funds ETFs?

You can profit from ETFs through dividends and capital gains, which combine to give you a "total return" on your investment. Learn how to maximize your returns and make the most of your ETF investments.

Virgil Wuckert

Senior Writer

Virgil Wuckert is a seasoned writer with a keen eye for detail and a passion for storytelling. With a background in insurance and construction, he brings a unique perspective to his writing, tackling complex topics with clarity and precision. His articles have covered a range of categories, including insurance adjuster and roof damage assessment, where he has demonstrated his ability to break down complex concepts into accessible language.

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