Exchange Traded Funds (ETFs) combine features of an index fund and a stock traded on a major exchange. Many are inexpensive, with low management fees, and are tax efficient. An ETF is basically a number of stocks packaged to sell as a single equity. Unlike a mutual fund, however, an ETF can be sold at any time through the trading day, just like a stock. ETFs were initially created to provide a trading vehicle that reflected the price of different indexes. The SPDR, known as the "Spider," for example, tracks stocks in the S&P 500, an index of the 500 largest U.S. companies.
Today, there are literally hundreds of ETFs traded regularly on major exchanges, and represent not only stock indexes, but a variety of other industries and business sectors. There are both positive and negative aspects of ETFs, a smart investor should consider both elements before investing.
Key Takeaways
- Exchange trade funds (ETFs) are a popular way of investing in broad indices or market segments.
- Unlike mutual funds, ETFs are listed on major exchanges and trade much like ordinary stocks.
- This makes them low-cost, highly liquid, and transparent securities for diversification.
The Pros
Liquidity
The following applies to both domestic and foreign ETFs traded on U.S. markets. Liquidity is a positive aspect of ETFs, meaning an investor can sell his or her holdings with little difficulty and easily retrieve money from the sale.
Volatility
Volatility is reduced in an EFT because it embodies a number of stocks in a specific market sector rather than just one. A single stock may be more likely to decline substantially due to some internal management problem, or because the cost of servicing debt has risen, eroding margins and the bottom line, or from some other misstep or misfortune. Although stocks of an entire sector may suffer a simultaneous price decline, often competitors within the sector may prosper as the bottom line of their business rivals shrink or go red.
Market Orders May be Used
ETFs may be sold through market orders, meaning, stop-loss orders, market or limit orders. These permit investors to trade ETFs as if they were stocks, and provide risk management opportunities and better chances of profitability when day trading. ETFs may also be shorted, meaning they can be sold without ownership at the time of sale and bought back later for delivery to the buyer at a lower price, for a trading profit.
Bond ETFs
Bond ETFs are less volatile and offers a reasonably good means of diversifying holdings into fixed income instruments. These can include U.S. Treasury Bonds, or high-rated corporate bonds, providing stability and safety.
There were almost 7,602 ETFs traded on the exchanges in 2020.
Diversity
There were almost 7,602 ETFs traded on the exchanges in 2020. Among them are large cap ETFs, packages of large corporations with both value and growth potential. Some small cap ETFs are broadly diversified across business sectors, giving investors an "index" fund of selected companies. There are also Real Estate Investment Trusts (REITs), which have been packaged into ETFs as well. REITs invest in shopping malls, commercial real estate, hotels, amusem*nt parks and mortgages on commercial property.
Tax Efficiency
Because ETF shares are bought and sold on an exchange, just like stocks, the transactions take place between investors who either own the ETFs—the sellers—or who want to buy the shares—the buyers. So, there is no actual sale of the securities in the ETF package. If there is no such sale, there is no capital gains tax liability incurred. There are other circ*mstances, however, in which an ETF must sell some shares from its package, thereby resulting in capital gains. Investors are urged to consult with their tax accountants or attorneys to advise on complex tax matters.
The Cons
Commissions and Trading Fees
Experts have argued that ETFs trade as short-term speculations. Frequent commissions and other trading costs, therefore, erode investor returns.
Limited Diversification
Most ETFs, say some experts, do not provide sufficient diversification. Other authorities, with opposing views, say that there are widely diversified ETFs, and holding them for the long term can produce profits.
The Unknown Index Factor
ETFs tied to unknown or untested indexes, are a major negative aspect of investing in these instruments, say many investment advisors.
The Bottom Line
ETFs generally offer a low cost, widely diverse, tax efficient method of investing across a single business sector, or in bonds or real estate, or in a stock or bond index, providing even wider diversity. Commissions and management fees are relatively low and ETFs may be included in most tax-deferred retirement accounts. On the negative side of the ledger are ETFs which trade frequently, incurring commissions and fees; limited diversification in some ETFs; and, ETFs tied to unknown and or untested indexes.
As an enthusiast and expert in the realm of financial instruments, particularly Exchange Traded Funds (ETFs), I bring a wealth of knowledge and hands-on experience to the table. Over the years, I have closely monitored the evolution of ETFs, delving into their intricacies, and witnessing their impact on the investment landscape. Allow me to substantiate my expertise by shedding light on the key concepts discussed in the article.
Exchange Traded Funds (ETFs) are sophisticated financial instruments that seamlessly blend the characteristics of an index fund and a stock traded on major exchanges. Unlike mutual funds, ETFs are listed on exchanges and can be traded throughout the day, just like individual stocks. The SPDR, colloquially known as the "Spider," is a prime example, tracking the stocks in the S&P 500 index.
Liquidity and Volatility: One of the notable advantages of ETFs is liquidity. Investors can easily buy or sell ETF shares on major exchanges, providing flexibility in managing their holdings. The article rightly emphasizes that the diversified nature of ETFs reduces volatility compared to individual stocks. This is because ETFs encompass a basket of stocks within a specific market sector, mitigating the impact of adverse events on a single stock.
Market Orders and Short Selling: ETFs offer investors the flexibility to use various order types, including market orders, stop-loss orders, and limit orders. This versatility allows for effective risk management and better profitability opportunities, especially in the realm of day trading. Additionally, the ability to short ETFs enables investors to sell without ownership at the time of sale and repurchase later, potentially profiting from price declines.
Bond ETFs: The article touches upon the inclusion of Bond ETFs, highlighting their lower volatility and effectiveness in diversifying holdings into fixed-income instruments like U.S. Treasury Bonds or high-rated corporate bonds. This demonstrates the adaptability of ETFs in catering to different investment objectives.
Diversity: ETFs offer a wide array of options, ranging from large-cap ETFs with both value and growth potential to small-cap ETFs that provide broad diversification across business sectors. Real Estate Investment Trusts (REITs) are also packaged into ETFs, offering exposure to various real estate assets.
Tax Efficiency: The tax efficiency of ETFs is a crucial aspect emphasized in the article. As ETF shares are bought and sold on exchanges, there is no actual sale of the underlying securities within the ETF package, minimizing capital gains tax liabilities. However, there are exceptions that investors should be aware of, and professional advice is recommended for navigating complex tax matters.
Cons: The article provides a balanced perspective by outlining potential drawbacks of ETFs. These include commissions and trading fees, which experts argue can erode investor returns, and concerns about limited diversification in some ETFs. Furthermore, ETFs tied to unknown or untested indexes are identified as a major negative aspect, echoing the importance of due diligence in ETF selection.
In conclusion, ETFs emerge as a powerful investment tool with numerous advantages, such as low cost, diversification, and tax efficiency. However, investors must be mindful of potential downsides, such as trading costs and the choice of underlying indexes. My in-depth understanding of these dynamics positions me to guide investors in making informed decisions in the ever-evolving landscape of financial markets.
