Updated: Jul 12, 2020
We’re not the biggest fans of acronyms at Fempire Finance. I mean, just say it as it is, right? You should also know by now that we’re not the biggest fans of complex financial information, when it can be put in such simple terms - so we’re here to break down what an ETF is.
*please note this does not constitute as investment advice*
ETF stands for Exchange-traded fund.
In simple terms it’s a basket of items that you can invest in for example — a combination of stocks, bonds or commodities that you can buy and sell through a broker. ETFs allow you to buy and sell a range of different assets without having to buy all the components individually (efficiency savings 101)
So, how does it work?
Step 1: The ETF provider owns the underlying assets. They look at all stocks, bonds, commodities or currencies in the world (okay, slight exaggeration - they look at a lot of stocks, bonds, commodities and currencies) and create a basket of them.
Step 2: They then sell shares of the basket to investors.
Step 3: Shareholders own a portion of the ETF, but they don’t own the underlying assets in the fund.
Step 4: ETFs can be traded on exchanges and have unique ticker symbols that let you track their price activity.
While ETFs are designed to track the value of an underlying asset — be it a commodity such as gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from the asset.
What are the benefits?
It's not just one thing you are investing in, so you will benefit from diversification benefits of the various investing products
It's fairly easy
ETFs are usually cheaper to buy than mutual funds, and usually have lower fees than mutual funds. The average ETF carries an expense ratio of 0.44%, which means the fund will cost you £4.40 in annual fees for every £1,000 you invest
ETFs offer tax-efficiency advantages
Anyone with internet access can search the price activity for a particular ETF
You can buy and sell at any time of the day as they are traded on the stock market
What are the disadvantages?
If you're investing small amounts and at a frequent rate, there may be lower trading costs if you invest directly with a fund company
Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price and selling at the low price
Technical issues can create discrepancies when tracking their underlying index
ETF sales are not settled for 2 days following a transaction; so not technically available to reinvest for 2 days.
They are subject to commission fees from online brokers.
There is a risk the ETF will close
So, there we have it...the pros and cons of an ETF compared to mutual funds. ETFs are very similar to shopping, in your basket you can have different types of variations in your basket. If we stick with the shopping analogy, they can be all one flavour or one type. This next section explains the different types of ETFs you can get!
Stock ETFs: These comprise of stocks indexes like the S&P 500 or NASDAQ. The benefits of these are that they normally cater for longer-term growth as they are less risky than individual stocks, (but slightly more riskier than bond ETFs - we will come onto those)
Commodity ETFs: Commodities are raw goods, such as gold and crude oil.
Bond ETFs: You guessed it these are exclusively invests in bonds. They hold a portfolio of loans made by investors, e.g. U.S. Treasury, corporate, municipal, international, high-yield. Remember, even if there are no ‘buyers’ in the market, you are always able to sell a bond back to its issuer, so if you’re worried about that, a bond ETF might just be the one for you.
Bond ETFs don’t have a maturity date, so the most common use for them is to generate regular cash payments to the investor. .
International ETFs: These ETFs may include investments in individual countries or specific country blocs (Mr worldwide, if you’re a Pitbull fan) Foreign stocks are widely recommended for building a diverse portfolio,. International ETFs are typically less risky.
Sector ETFs: The U.S. stock market is divided into 11 sectors. Sector ETFs provide a way to invest in specific companies within those sector. So if you’re interested in pharmaceuticals, you can invest in health care, and the same goes for financial or energy sectors. With these ones it is easier to keep an eye on the news and track business. But beware these typically carry higher risk than broad-market ETFs.
Style ETFs: These are designed to track an investment style or approach. The two ones being large-cap value (companies with a market capitalisation of more than $10 billion) or small-cap growth ($2 - $10billion)