What is an Exchange-Traded Fund (ETF) & How to Invest in ETFs?

What is an Exchange-Traded Fund (ETF) & How to Invest in ETFs?

Reading Time: 17 Minutes

History

ETFs, or exchange-traded funds, have experienced elevated growth over the past years and remain a widely traded market today.

According to research, Canada produced the first ETF in 1990, mainly employed by institutional and corporate investors. Nathan Most is widely recognized as the inventor of the ETF in the United States (US). Most passed away in December 2004.

Nowadays, one of the most popular ETFs is the SPDR S&P 500 ETF Trust (SPY), which mirrors the S&P 500 and provides investors exposure to the entire index.

Defining an Exchange-Traded Fund (ETF)

An ETF serves as a basket of securities that can include asset classes, such as: equities, commodities, bonds, and foreign currencies. Essentially, ETFs trade on a stock exchange just like regular stocks.

When you invest in an ETF, you do not own the underlying assets. The shares or assets (assuming the ETF is physically backed) are owned by the ETF issuer, while you, the investor in the ETF, hold units in the ETF.

ETFs are categorized as active or passive:

• Active Manager:

Active managers select investments to generate a return for ETF investors. As the name suggests, fund managers are actively managing a portfolio of various securities.

• Passive Manager:

A passively managed ETF seeks to mirror the index it invests in. It cannot better the market because it mimics the index.

Passive funds often have lower management fees than active funds because they don't need a manager to keep an eye on the fund and generate investment ideas.

Basic ETF Terms and Concepts to Remember

• Expense Ratio:

The expenditure ratio is the investor's cost, expressed as a percentage. The expense ratio of an ETF is calculated by dividing its operating expenses by the average dollar value of its assets under management (AUM). The expenditure ratio indicates the proportion of a fund's assets allocated to administrative and other operating costs.

• Index:

An index is a collection of assets that have been chosen to be representative of a market or a submarket. It tracks a market's growth and provides investors and fund managers with a benchmark for comparison purposes. Some common equity indexes include the S&P 500 index in the US, the Straits Times index in Singapore, and the Hang Seng index in Hong Kong.

• Managed Fund:

As its name implies, a managed fund is managed on your behalf by an investment manager. Essentially, the investment manager delivers higher returns than the index.

• Physical ETF:

This represents an ETF whereby the ETF holds the underlying assets within the fund. Physical ETFs are sometimes lower risk than synthetic ETFs.

• Synthetic ETF:

A synthetic ETF tracks the underlying market, generally through derivative contracts. This is usually done through futures contracts.

ETFs, therefore, do not directly invest in underlying assets

Asset Allocation:

Depending on the investor's goals (long or short-term) and risk tolerance, asset allocation is a good way to manage risks and rewards. By adjusting the percentage of each asset in an investment portfolio and investing in diverse asset classes, greater returns can be achieved.

• Active Investing:

These are investments that are "actively managed" by a financial professional to attempt to outperform a particular index or benchmark in terms of their performance. Most of the time,

• Yield:

Yield tells investors how much income they can expect to earn in a period in relation to the market value or initial investment cost, It is normally a percentage of the investment amount.

• High-Yield Bonds:

Organizations typically issue a form of debt financing known as a "high-yield bond" with low credit ratings. Investors can expect a higher return on these bonds because of the increased risk. Due to the possibility of high income, high-yield bonds are frequently included in the investment portfolios of financial market participants.

Differences and Similarities Between ETFs and Mutual Funds

Similarities:

• Both ETFs and mutual funds refer to managed "baskets" of different types of securities, such as stocks and bonds.
• ETFs and mutual funds allow investors to gain exposure to diverse asset classes and specialized markets. They often offer greater diversification than a single stock or bond, and investors can use them to form a diversified portfolio by combining funds from several different asset classes.

Differences:

• ETFs can be traded on the stock exchange and are subject to price fluctuations. On the other hand, mutual funds can be traded once a day.
• ETFs do not require a minimum investment as they are bought as whole shares; this is sometimes called the "market price." A minimum investment is required to participate in various mutual funds, which is done to ensure that the fund meets its operational costs.

Types of ETFs:

The total number of ETFs needs to be clarified. But up until 2021, there were more than 10,000 ETFs globally, and the number is rising. The reason for so many ETFs is primarily due to demand and the ease with which they can be traded.

Commodity ETFs:

Investing in commodities such as gold, silver, or oil can be traded very profitably using ETFs.

ETFs are a compelling alternative to equities that can further diversify your portfolio and reduce the risk you are exposed to. They frequently employ derivatives rather than directly owning the underlying asset, such as gold, on which they speculate. Derivatives are financial instruments that are based on the price of a commodity but have extra risks, like counterparty risk, that need to be considered.

Sustainable ETFs:

Sustainable ETFs are expanding quickly, and traditional investment trading strategies combine environmental, social, and governance considerations in sustainable investing. Investors are becoming more interested in sustainable investing. This can be caused by changes in population trends and personal beliefs, such as a desire to protect the environment, new rules from the government, and different ideas about risk.

Currency ETFs:

ETFs that invest in currencies can track a single currency or a basket of currencies; the currency itself or derivatives of the currency can be purchased with the ETF fund. You need to monitor price action just like you would with a Contract For Difference (CFD).

Bond/Fixed Income ETFs:

It is essential to spread your investments. To put it another way, spreading out the risk associated with your investments is prudent. Most financial advisors may suggest investing in fixed-income bonds, considered safe investments because of government backing.

How ETFs Work?

As stated above, ETFs are similar to CFDs, where you don't own the underlying asset. The fund provider usually owns the asset, and shareholders own a portion of the ETF but not the asset itself. Some ETFs pay dividends or reinvest in the stock.

The values of the stocks in the basket constantly vary, so the basket's value also varies. When freely traded on the market, the price of a basket share will only be partly in line with the real value of what it represents.

Below are three basic steps showing how ETFs work:

1. The ETF provider decides which assets make up the ETF.
2. Traders purchase shares in the pool of assets.
3. The ETF is traded on an exchange similar to stock trading.

ETFs and Taxes: What You Need to Know

Investors must be aware of their tax liabilities regarding ETFs as it is their responsibility to avoid a nasty surprise at tax time. ETFs can generate capital gains taxes. However, they are more tax-efficient than mutual funds because of their low turnover.

How to Start Investing in ETFs

• Open a trading account with FP Markets, live or demo.
• It is considered prudent to use a demo account to hone your skills until you fully understand how to trade ETFs.
• Once you've decided on the ETF in which you want to invest, conduct extensive research.
• Only after completing the above should you consider opening a live account using real money.
• Devise a trading plan and investment strategy, and set realistic investment objectives.
• Establish a risk management plan.
• Start trading and watch your trades closely.

How to Select the Right ETF

1. First, decide on an asset class, for example, equities, bonds, commodities, or currencies. Allocate a percentage you wish to use from your portfolio.
2. Select the index you want your ETF to track, or you can select one or as many indices as you are comfortable investing in.
3. All aspects should be considered before selecting the right ETF for your needs.

 Guidelines:

• Tax liabilities:

As mentioned in this article, your tax liabilities are the trader's responsibility.

• Fund size:

A fund of US$100 million is a decent size, which should make it a reasonably safe fund concerning the fund failing (insolvency).

• How old is the fund?

ETFs with 3 years or more having a good track record should assist in identifying any risks.

• Trading cost:

Brokerage fees can vary with the broker; check them before you begin to trade. Then there is the bid-ask spread, the difference between the buy and sell price.

• Use of profit:

Depending on your situation, the fund can pay your profit directly to yourself or allow you to invest as you wish. Or an accumulating ETF, where your fund manager reinvests your profit into the ETF and hopefully grows your portfolio over time. It's your personal choice.

• Where is your fund located? An important factor in determining tax liabilities.

Pros and Cons of ETFs

Investing in ETFs has both pros and cons, but most of the pros outweigh the cons (at least for ETFs that track a major index fund).

Pros:

• Diversity:

Diversification means investing in a wide range of companies within each asset class and in a range of different asset classes. This is one of the most important goals of any good ETF plan.

• Costs:

As stated above, many ETFs are cost-effective. Like the Vanguard Total Stock Market (VTI), it has an expense ratio of 0.04%. Also, the Spider S&P 500 Index ETF (SPY), one of the oldest and largest ETFs, has an expense ratio of 0.09%.

Cons:

• LIquidity:

One type of exchange-traded fund ETF asset class, for instance, that is less liquid than others is bonds. Regarding some asset classes, such as bonds, commodities, real estate, and foreign securities, it may be more difficult to sell ETFs exactly when you want to.

• Capital Gains Tax:

Several ETFs are subject to capital gains taxes. Choose an ETF that reinvests your capital gains and does not accumulate capital gains tax.

• Market losses:

ETFs are not without risks; this is generally where your fund manager comes in to protect you to the best of their ability from rising and falling markets. However, there are some fairly stable ETFs, such as the iShares Core S&P 500 ETF (IVV) and Vanguard Growth ETF (VUG), to name a few.

Conclusion

While ETFs are fairly low-cost and easy to access, caution is advised. Understand what you're buying. Choose a reliable brokerage account, such as FP Markets, great customer service, and a section devoted to ETFs: https://www.fpmarkets.com/etf-trading-with-fp-markets/.

 Work Cited

Charles Shwab. “ETFs and Tax liabilities What You Need to Know.” Charles Shwab, 2022. Accessed

January 4th, 2022.