An ETF (exchange-traded fund) is similar to a mutual fund as it’s a pooled investment security.
They also track specific indexes, commodities, or sectors.
The main difference between ETFs and mutual funds are that ETFs can be bought or sold on the same exchanges, the same way as regular stocks.
The New York Stock Exchange, NASDAQ, and Toronto Stock Exchange are examples of exchanges where everyday investors can buy and sell ETFs.
Like mutual funds, ETFs can be structured to focus on a specific sector or have proverbial hands in multiple cookie jars.
They can even track more abstract concepts like specific investment strategies.
The first and one of the most well-known ETFs that track the S&P 500 index> was SPDR S&P 500 ETF, which can be found through the ticker SPY.
This ETF was created in 1993 and is still actively traded today.
How Does an ETF Work?
Investors who put their money into an ETF own a portion of the ETF, but do not directly own the actual assets that the ETF holds.
The fund provider owns all of the assets in the ETF and completes trades to provide value for their investors.
Investors in an ETF have the option (depending on the ETF) to receive lump sum dividend payments for the assets that comprise the ETF or reinvest those dividends back into the ETF.
ETFs track the value of assets in their portfolio.
However, they trade at a different price that is determined by the market.
Additionally, due to expenses incurred such as management fees, returns will vary from an ETF to its underlying assets.
Did You Know?
The first ETF in the world was launched right here in Canada in 1990.
Types of ETFs
1. Commodity ETF
Commodity ETFs invest in and bundle securities for companies that deal in raw goods that can be bought and sold, such as gold, steel, rice and others.
As with any investment, it is recommended to research what the investment will yield.
Essential things to understand are whether the ETF invests in shares of companies (like a gold mining company) or in the physical inventory of these goods (holding actual gold).
2. International ETF
International ETFs are a relatively low-cost way to invest in foreign economies.
They can be geared towards specific countries or country blocs and are a great way to diversify a portfolio from strictly domestic investments.
3. Equity ETF
Equity ETFs invest in securities of various companies.
These types of ETFs are not as risky as owning individual stocks but are still riskier when compared to other ETFs.
They are usually considered suitable long-term capital growth investments.
4. Bond ETF
The most common use for Bond ETFs is to generate cash flow for those invested.
Bond ETFs don’t have a maturity date, unlike common bonds and the payments investors receive come from the interest collected by individual bonds in the ETF.
They are generally considered low-risk investments.
5. Sector ETF
Sector ETFs provide a way to invest in a targeted market sector.
Each company is grouped into one of many sectors such as industrial, financial, or healthcare sectors.
These ETFs are good for investors who feel strongly about the future potential of specific sectors or trends in the market and can be lucrative if the right investment area is identified.
On the flip side, since these ETFs are not as diversified as others, they risk losing part of the investment if the sector performs poorly.
That said, sector ETFs can diversify an investment within a sector and mitigate the risk of investing in one or two companies that may or may not fail.
6. Currency ETF
Currency ETFs expose investors to currencies and the changes in the exchange rate between currencies.
Currency ETFs are usually passively managed, and the assets (currencies) are held in a primary country.
They are typically used to speculate on forex markets, hedge against currency risks, and for general portfolio diversification.
7. Real Estate ETF
Also known as Real Estate Investment Trust (REIT), these types of ETFs attract investors by having to pay out 90% of their taxable income to their shareholders.
In terms of yields, they are extremely attractive even with the volatility compared to more “stable” ETFs like bonds.
They are excellent sources of income when inflation and short-term interest are low.
8. Sustainable ETF
Within the realm of sustainable investing comes the term “environmental, social, and governance awareness” (ESG) and socially responsible investing.
Sustainable ETFs aim to invest in companies that follow sustainable business practices across all sectors and industries.
Advantages of ETFs
Transparency
An ETF’s holdings are publicly shared each day.
Anyone with an internet connection can check the price of an ETF that interests them.
This transparency allows users to keep an eye on the ETF’s portfolio and sell their portion if it moves into a sector above the allotted risk tolerance.
Diversification
ETFs not only allow investors to put money in asset types such as stocks, precious metals and others, they also allow the ability to diversify across different industries.
An ETF can be invested in both oil and EV, where one can cover the other if dips are in the market.
This type of balance helps reduce investment risk and lowers the cost of investing in each industry individually.
Tax Benefits
For most ETFs, capital gains tax is only incurred during the sale of the investment, unlike mutual funds.
In an actively managed mutual fund, the fund managers incur both short-term and long-term capital gains taxes with each trade that occurs over the lifetime of the investment.
Those taxes are only applied when the investor chooses to sell with an ETF, giving the investor more control over managing tax implications.
Disadvantages of ETFs
Risk of Closure
Although slim with the bigger ETFs, there is always the chance that the fund’s assets don’t cover its administrative costs.
When that happens, the course of action is that the assets are liquidated, and the ETF will sell everything at its current market price, which may mean those who bought in will lose a part of their investment.
Trading Costs
With mutual funds, trading costs may end with the expense ratio.
The costs associated with ETFs may not end there.
Since they are traded on exchanges, the transactions associated with buying and selling may come with commission fees.
Issues with Liquidity
ETFs without a high daily trading volume can be harder to sell when the time comes to liquidate.
