Exchange Traded Fund: The Ultimate Guide

June 15, 2022

Areej M Alturki
Founder, Nakla

An exchange-traded fund (ETF) is a collection of assets that trade on a stock market the same way stock does. Keep reading to understand in detail.

Exchange-traded funds (ETFs) have skyrocketed in recent years as a perfect substitute for mutual funds since their launch in 1993. These instruments, which are a basket of assets are meant to mimic an index with minimal management fees and improved intraday price clarity. This might aid both organizations and consumers. 

This article will dive you deeper into the fundamentals of exchange-traded funds, their advantages and disadvantages, and many more. 

What is an ETF?

An ETF is a stock portfolio that mirrors the structure of an index, such as the Sensex or the Nifty. Exchange-traded funds values represent the net asset price of the stock bundle wherein it invests. It is comparable to mutual funds in several aspects. 

They are basically an index funds published and sold on trading platform like equities and are passively handled. Mutual funds seek alpha by beating a market reference, while ETFs seek to follow and mimic the applicable index's performance. You must have a trading profile with a brokerage firm to trade in this financial instrument.

ETFs are among the most essential and profitable products developed in recent decades for small investors. They have several advantages and, when leveraged intelligently, are a fantastic vehicle for achieving an investor's investment objectives.

How do ETFs work?

An ETF is purchased and traded much like a company share when the equity markets are open during the daytime. An Exchange-traded fund similar to stocks has a ticker icon, and intraday cost data is easily accessible during the trading day.

ETFs enable investors to invest in a fund that replicates the success of a portfolio of securities (often an index). This fund's parts can be purchased or sold immediately on the exchange. The cost is analyzed by a willing buyer and seller, similar to an equity share. Hence, the cost of an ETF would keep on fluctuating amid trading hours based on the modification in the cost of the underlying stocks.

A market maker is a notion that exists to ensure that investors have appropriate volatility and a reasonable price. Market makers have authorized dealers that issue a two-way quotation — purchase and trade — to guarantee that the transaction is conducted at an affordable rate to the NAV and not at a massive margin.

Here's a quick rundown of how ETFs work:

  1. An ETF supplier examines the array of assets, such as equities, securities, commodities, or currencies, and constructs a bundle of them, each with its symbol.
  2. Investors can purchase a share in that portfolio in the same way they would buy stock in a firm.
  3. Purchasers and traders trade the ETF on exchange across the day, much like stocks.

ETF Examples

The following are some examples of prominent ETFs on the marketplace currently. Some ETFs monitor a ETF stock index, resulting in a comprehensive portfolio, while others potential industries.

  • The SPDR Dow Jones Industrial Average (DIA) ("diamonds") portrays the Dow Jones Industrial Average's 30 equities.
  • JP Morgan Betabuilders U.S. Equity ETF (BBUS)
  • iShares MSCI Saudi Arabia ETF
  • Franklin FTSE Saudi Arabia ETF
  • Commodity exchange-traded funds reflect commodity markets such as silver (SLV), crude oil (USO), and natural gas (UNG)
  • Schwab Emerging Markets Equity ETF (NYSEMKT: SCHE) – Businesses from developing nations.
  • ETF Vanguard High-Dividend (NYSEMKT: VYM) — Stocks with above-average dividend yields
  • The Schwab US REIT ETF (NYSEMKT:SCHH) invests in real estate investment trusts.
  • Schwab Aggregate Bond ETF in the United States (NYSEMKT: SCHZ) — Bonds of various maturities and maturities

How to invest in ETF?

There are several methods to invest in exchange-traded funds, and the method you choose is primarily a matter of personal taste. ETF investment is only a few mouse clicks away for hands-on investors. These assets are common among online brokers, while the number of products (and associated costs) varies for each broker.

Robo-advisors build their portfolios out of low-cost ETFs on the opposite side of the scale, providing clients hands-off accessibility to these assets. One positive trend for ETF buyers is that several big brokerages have reduced their stock, ETF, and derivatives trading fees to $0.

Let's look at the steps of investing in ETFs:

Create a Brokerage Account

Before purchasing or selling ETFs, you must first open a brokerage account. Because most internet brokers now provide commission-free equity and ETF trading, money isn't an issue. The best line of action is to examine the capabilities and platforms of every broker. If you're a beginner investor, you should look for a broker who provides a wide choice of teaching tools.

Explore ETFs

The next and perhaps most crucial stage in ETF investing is conducting research. There are several ETFs available on the market today. One thing to remember while conducting research process is that these financial instruments are not the same as individual products like stocks or bonds. When investing in an exchange-traded fund, you must consider the big picture regarding the area of business.

Here are specific queries to analyze about when you conduct your research:

  • What is your investment timeline?
  • Are you searching to invest for earning profit or growth?
  • Do you have any preferred industries or investment vehicles?

Examine a Trading Strategy

A smart trading approach for new ETF investors is dollar-cost averaging or phasing out your transaction fees over time. This is because it smoothes out value over time and guarantees a systematic (rather than haphazard or erratic) approach to investment.

It also helps novice investors understand more about the complexities of ETF investing. As they gain trading experience, investors can graduate to more complex strategies such as swing trading and area rotation.

Let the ETF do its Work

It's crucial to remember that this kind of investment are typically intended to be low-maintenance investments.

Younger investors have a nasty habit of reviewing their accounts far too frequently and reacting emotionally to significant market changes. In reality, excessive trading is the primary reason why the ordinary fund investor screws up the market over time.

So, once you've invested in some outstanding ETFs, the best suggestion is to let them be alone and do what they're supposed to do i.e. generate exceptional ETF investment gains over lengthy periods.

Advantages of Investing in ETF

Trading Flexibility

When the markets are open, exchange-traded funds are purchased and sold. During regular exchange periods, the price of ETF units is continuous. Share prices fluctuate during the day, owing mostly to the fluctuating intraday worth of the fund's underlying assets. ETF investors very well know their expenses on ETF stocks and how much they earned after selling them in a matter of seconds.

The near-instantaneous dealing of such shares makes intraday portfolio management a breeze. It is simple to transfer money between asset types, such as equities, notes, or commodities. Investors may effectively allocate their funds to the investments they choose in an hour and then adjust their distribution in the next hour. That is not usually advised, but it is possible.

Cost-effective

ETFs are passive funds that follow indexes, metals, or securities for a fraction of the price of the underlying assets.

Because of the passive nature of such funds, they have a cheaper expense ratio in comparison to mutual funds. Fund management expenses are reduced, resulting in a lower expense ratio, creating additional savings and perhaps enhancing dividends over time.

ETF operating expenses are cheaper as fund management charges are minimal; service charges are practically nil because brokers handle client support, and fund administration expenses for these funds can be reduced. As a result, ETFs are regarded as cost-effective investments.

Diversification

Investors who lack knowledge in specific industries, genres, regions, or nations may rapidly seek to get portfolio coverage in such areas. Given the extensive range of sector, genre, industry, and nation classifications present, ETF shares may be capable of giving an investor with convenient access to a particular market area.

ETFs are currently traded on almost all large asset classes, commodities, and currency exchanges worldwide. Furthermore, unique new exchange-traded funds forms represent a specific investing or trading approach. For instance, with ETFs, a trader may continually purchase or sell stock or trade in the world's greatest paying currencies.

Convenience

Investing in ETFs is handy since it allows you to purchase and sell at any moment. ETFs can also be used to perform intraday transactions.

You never have to fret about repayments with Exchange Traded Funds because market activity results in transferring units and does not affect the AUM. As a result, the tracking error of index ETFs may be smaller than that of index funds. As a result, they are a convenient investment alternative.

Transparency

You may examine the fund NAV using ETFs at any moment during market hours. During the trading day, the NAV (Net Asset Value) price of an ETF investment may fluctuate. This openness is significantly superior to that of typical open-ended mutual funds, which do not price their finances until the end of the day. With open-ended mutual funds, clients may not realize how much they earned or lost until the end of the day.

Disadvantages of Investing in ETF

Lower Dividend Yields

Dividend-paying ETFs exist, but their yields may not be as high as holding a high-yielding stock or group of securities. The dangers involved with such fund ownership are often smaller, but if an investor is willing to face the risk, dividend returns on equities may be substantially greater. While you can choose the stock with the most significant dividend yield, ETFs monitor the whole market to lower the total yield.

Operating Expenses

Even though most exchange traded funds are handled passively, fund managers pay fees as part of their usual business activities. These expenses are represented in the fund's expense ratio, which is the proportion of a person's investment that is given to the fund every year. ETF cost ratios were typically less than 0.5 percent as of 2020.

Even though these charges do not function in the same way as fees, the result is the same: a greater expense ratio reduces an investor's overall profits. Employee wages, custodial operations, marketing expenditures, and the fund manager's skill in selecting and handling the underlying assets may all be covered by the fee.

Prices Could be High

Many people have compared trading ETFs to dealing with other funds; however, the charges are more significant when comparing ETFs to investing in a single firm. Stock does not have a management fee, even though the real compensation paid to the dealer is the same.

Furthermore, they are more apt to follow a low-volume index when niche ETFs arise. As a result, a broad bid/ask spread may emerge. Investing in actual shares may provide a greater return.

Tracking Errors

Even though an ETF management will make every attempt to maintain its fund's investment performance in line with the index it monitors, this may be easier said than done. For various causes, an ETF may deviate from its targeted benchmarks. For instance, if the fund manager wants to swap out assets or make other modifications, the ETF may not perfectly mirror the index's holdings. As a result, the ETF's performance may differ from that of the index.

Conclusion

ETFs may be the most incredible option for mutual funds if an investor seeks a reasonably risk-free investment. It enable portfolio diversity and market exposure at a cheap cost. They are suitable for gauging market performance without suffering significant losses.

Lesser risk, however, equals lower capital gains and revenue. Furthermore, because ETFs just monitor a market index without attempting to outperform it, they may vanish entirely if that market index becomes obsolete.

FAQs

Is it worth investing in ETF?

ETFs are an excellent method to begin starting as they provide built-in diversity and do not require significant amounts of cash to invest in various equities. You may trade them like equities while yet maintaining a diverse portfolio.

Are ETFs suitable for beginners?

ETFs are ideal for both novice and experienced stock market investors. They're cheaper than investing in individual securities, are accessible via Robo-advisors and conventional brokerages, and are less volatile. (Robo-advisors are online investment advisors that create and maintain your portfolio for you, frequently leveraging ETFs due to their low cost.)

How do I pick an ETF?

When picking an ETF, it's essential to check whether the ETF you have shortlisted trades in ample volumes regularly. Daily trading volume is perhaps the most prominent ETF that exceeds millions of shares. Though most ETFs carefully monitor their underlying indexes, others may not follow them as tightly as they ought to. All factors being equal, an ETF with low tracking mistakes is more desirable than one with high tracking errors.

How long do you hold ETFs?

If you hold ETF for less than a year, you may witness short-term profits. However, if you hold your ETF for more than 3 years, you may get long-term capital revenue. Here, the holding period indicates the tenure you keep your shares. It starts when your buy order is completed and ends when your sell order is accomplished. 

Can you get rich off ETFs?

ETFs may make you a fortune, despite the fact that many of those never outperform the market. In reality, the broader market has enough upside potential to support seven-figure retirement money. Hence, it's wise to select the cost-efficient funds wherein a more significant amount of the ETF's earnings trickle via the bottom line.

Do ETFs pay dividends?

ETFs are obligated to distribute any dividends received for shares held in the fund to its holders and hence dividends can be paid in cash or extra ETF shares. However, distributing the proceeds is entirely up to the individual provider. The dividend profits may be distributed to equity investors in the format of a cash distribution or reinvestment in further shares of the ETF.

Can I sell ETF anytime?

ETFs trade like stocks and may be purchased or sold at any time throughout the trading day. They may be sold short since they move like equities, allowing you to benefit if the ETF value drops rather than rises. Furthermore, most ETFs feature has associated options contracts, enabling users to manage a considerable number of shares with far fewer funds than if they held the shares directly. 

How much should I invest in ETF?

Typically, the minimum amount necessary to invest in an ETF is smaller. Investors can purchase as low as one share of an ETF, which is not generally allowed with index mutual funds. 

Index funds demand a minimum spend of Rs.100 for the full payment and SIPs. The value, however, differs between funds. Investors have the benefit of selling short or buying on margin.

What time of day is best to buy ETF?

The middle of the day is typically said to be the preferable time when buying ETF. And if the ETF contains foreign (European) equities, dealing in the early hours of the day will assure you obtain the best pricing. As the value of an ETF is generated from its core components, waiting for all components to launch and their instability to decrease creates a better atmosphere for buying or selling the ETF.

Are ETFs suitable for the long term?

ETFs may be excellent long-term investments since they are tax-efficient, but not all ETFs are suitable long-term investments. Inverse and weighted ETFs, for instance, are intended to be kept for a brief amount of time. Generally, the more passive and diverse an ETF is, the better it is as a solid investment.

Stay Updated with the Latest Trends

Create an account for free and get started instantly.

Now, what to wait for, it’s time to put your funds to work today.

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.