Investment 101: Exchange Traded Funds

Author: Nidhi Sood on Jul 28,2022
SP Exchange Traded Funds


An exchange-traded fund (ETF) refers to a fund that owns securities such as stocks, bonds, or other assets. It is a basket of investments that trade on an exchange like an individual stock. An ETF functions much like a stock; it’s the same thing with a few key differences. Anyone who invests their money and wants to see it grow can benefit from learning about investments and ETFs

An ETF is a basket of assets traded on a stock exchange. It can be invested in a single asset like gold or real estate or a diverse portfolio of investments. While each ETF is unique, they typically have one or more goals, such as generating a high return, reducing risk, or investing in a specific sector. 


What is an Exchange Traded Fund?

An exchange-traded fund (ETF) is a fund that owns securities such as stocks, bonds, or other assets. It is a basket of investments that trade on an exchange like an individual stock. An ETF functions much like a stock; it’s the same thing with a few key differences. The critical difference between an ETF and a mutual fund is that an ETF is traded on a stock exchange while a mutual fund is not. That means two things.

  •  First, the investment options are more diverse. ETFs may be traded around the clock, whereas mutual funds have a limited trading window (usually 9-5 Eastern Standard Time). Less than 1% to 5% of total costs can be incurred. A lower cost-to-income ratio is preferable. There are low-cost ETFs available if you're looking to invest a little amount.


  • Second, ETFs are diversified differently. Some ETFs focus on a specific country or industry, while others are much more diversified. To diversify your portfolio, you should choose a well-diversified ETF.


  • Third, ETFs have different benchmarks. Some track a single country’s stock market, while others track a basket of countries. Some ETFs track the entire global stock market. It’s essential to choose the proper benchmark, depending on your goals.


  • Fourth, ETFs are taxed differently. Most ETFs are taxable, meaning you’ll owe taxes on any profits. However, you can often defer taxes if you hold the ETF in a taxable account.


How Does an ETF Work?

Let’s say you want to invest in the healthcare industry. You could buy shares of a single healthcare company, but that would make you highly vulnerable to a single stock.S&P 500 Health Care Sector Index exchange-traded fund diversifies your investment throughout the healthcare sector. The health care ETF would own different healthcare stocks, like Johnson & Johnson or Pfizer, weighted by their relative size in the industry. You’d be exposed to all the ups and downs of the health care stocks, but with a lesser risk of losing much money if one or two companies go bankrupt.

 You can invest in ETFs through most online brokerages or financial companies that let you buy and sell stocks. They’re super simple to use, but there are a few things to keep in mind. First, the differences between an ETF and a mutual fund can affect your investment strategy. 

Second, each ETF has its unique fee structure. You can tell how much each. The key to successful diversification is to invest in different asset classes. For example, you could create a balanced portfolio by combining an ETF that focuses on stocks (e.g., S&P 500) and one that invests in bonds (e.g., a short-term U.S. Treasury bond fund).


Advantages of Exchange Traded Funds

-ETFs have much lower trading costs  As compared to actively managed mutual funds. This makes them a better option for long-term investments. Additionally, some providers offer commission-free ETF trading. 

- Diversification Unlike mutual funds, ETFs are a collection of assets. This makes them a more diversified investment compared to mutual funds. 

- Liquidity  ETFs have a high level of liquidity, meaning you can sell them whenever you want.

- Transparency Taking the time to do this will go a long way toward helping you avoid mistakes. These are publicly-available documents, so it’s not hard to find one and start reading.

-Easy purchasing Another advantage is that you can purchase or sell an ETF whenever the market is open, unlike mutual funds purchased at the end of the day. 

-Reduce risk  ETFs are more diversified than most mutual funds, which helps reduce risk. Many ETFs track an index, which lets you go passively by allowing the index to do the heavy lifting. Index funds are also a low-cost way to access a diversified portfolio.

-The cost-to-income ratio  It is the first item you should look at. This is the yearly percentage cost of holding an ETF. You can’t invest with a negative expense ratio, so ideally, you want something below 1%. You’ll also want to look at the diversification of the fund. You want to be sure that your ETF holds assets that match your overall risk profile. The closer the ETF’s holdings are to your risk profile, the more likely you will achieve satisfactory results. Next, you’ll want to look at the assets that make up the ETF. You’re investing for the long term, so you don’t wish to have assets that are likely to drop significantly in value. Ideally, you want investments that have a positive outlook for the long term. Stay away from assets that might be negatively impacted by the current trade policies of the U.S. government.

 -Tracking the ETF record is possible  You want to ensure the fund has a good history of meeting its expectations. Ideally, you want to see that the fund has outperformed other similar funds over the last few years. Any given ETF might hold assets such as stocks, bonds, or real estate. Still, if it contains more than 10% of its assets in any one of those categories, it is not diversified. 

Similarly, any ETF should not hold more than 5% of its assets in any industry. The second is the expense ratio. An ETF with an expense ratio of 1% is not necessarily worse than an ETF with a 0.5% expense ratio. 

-The cost vs benefit ratio  For the most part, investors are more concerned with delivering than receiving. It makes them an excellent choice for both novice and experienced investors.. ETFs typically have lower trading fees than other funds. You don’t have to buy and sell often because they’re traded like stocks. 

- Tax efficiency ETFs have lower tax rates than mutual funds or real estate investment trusts since they are considered a stock (REITs). - The need for a wide range of services and products. An ETF that tracks a wide index will own several equities in order to lower the overall risk involved in investing. This is especially beneficial for those investors with less capital.- Simplicity. The process of purchasing and selling ETFs is very straightforward. You buy them on a stock exchange and sell them by placing a sell order.


Disadvantages of Exchange Traded Funds

- Lack of human interaction  Fund managers use their sector knowledge to make investment decisions for mutual funds, which are actively managed. ETFs are passively managed, which means the index they track is used to decide when to buy and sell stocks.

 - Volatility Although ETFs can be a great diversifier, they can also be highly volatile. Because they track a particular index, they are more susceptible to dramatic swings when that index dives.

- Lack of customization  You can buy ETFs that track various indexes, but you can’t buy one that tracks a single company or industry. - No guaranteed return. Unlike with a mutual fund, there are no guarantees that an ETF will return a certain amount. The fund could perform well, but there’s always a chance that it doesn’t.


Final Words

Exchange Traded Funds are a great way to diversify your investment portfolio. They are a fund that tracks a particular index and owns a basket of stocks representative of that industry or sector. You can buy and sell ETFs through an online brokerage account daily and create a diverse portfolio by combining several funds. Keep in mind that ETFs have lower trading costs than mutual funds but charge higher fees. Also, ETFs are passively managed, which means they track a particular index and are more susceptible to dramatic swings when that index dives. Continue reading for more investment-related information and advice.