Since its inception in the early 90s, the market for Exchange-traded Funds (ETFs) has grown exponentially. Today, there are over 7,000 ETFs trading across the world, with the market’s total valuation hitting the $6.37 trillion mark. This is according to a report by ETFGI, a world leader in independent research on global trends for ETFs and ETPs markets. This dynamic growth in the ETF market has attracted more investors, following the many benefits that come with investing in Exchange-traded Funds. Market experts agree that the benefits of ETFs outshine their pitfalls. This guide highlights everything that you need to know about ETFs, including benefits and risks associated with these securities.
What is an Exchange-traded Fund (ETF)?
An ETF is a security that comprises of a collection of different assets, including bonds, indices, stocks, and commodities. All the assets within an ETF are divided into shares, for which investors can hold ownership in the ETF company. Just like stocks, ETFs are traded on stock exchanges, with their prices changing on a daily basis due to trade activities. ETFs are designed to track an underlying market index. ETFs compare with mutual funds in various aspects, such as the pooling of resources to invest in multiple assets. However, while mutual funds trade at the closure of trading day, ETFs trade intra-day.
Benefits of Investing in ETFs
Trading ETFs comes with plenty of benefits . Here is a brief highlight of these benefits.
This is the number one reason why most investors go for exchange-traded funds. Investors are in pursuit of securities that will expose their portfolio to the desired market segment, which is why ETFs are an ideal choice. There are thousands of ETFs available in the market today, covering virtually every industry, index, sector, and commodity. This form of diversification enables traders to reduce the concentration of risk in a portfolio.
When choosing an investment, liquidity is always an essential factor to consider. ETFs are highly liquid, making it easy for investors to buy or sell them over the trading day. This liquidity also makes it easy for traders to enter and exit trading positions easily.
ETFs are one of the few security options that make it possible for investors to diversify their portfolios at relatively low costs. Unlike mutual funds, ETFs have streamlined operation costs. They are also cheaper to purchase compared to acquiring a wide range of individual shares.
Relatively High Returns
Typically, every risky investment is known to offer very high yields, and ETFs are not an exception. Yields generated by an ETF are usually distributed in the form of dividends, just like most stocks. Investors will have dividend payments wired into their brokerage accounts, typically on a quarterly basis.
ETF Tax Benefits
In most cases, funds generate capital gains throughout the life of the asset, such as mutual funds. As a result, capital gain taxes are imposed on a fund for its entire trading life. For ETFs, however, capital gains are only generated upon the sale of an asset. Consequently, investors are left with the option of imposing capital gains taxes on themselves when they wish. However, you will still have to pay taxes on your earned dividends upon distribution.
How to Trade Exchange-traded Funds
The process of trading ETFs does not have to be complicated. This step by step guide highlights the most important phases of the ETF trading process.
Step One: Set Up Your Brokerage Account
You will need a brokerage or trading account for you to buy and sell an ETF. As a beginner, you may need to set up a full-service brokerage account. This account will give you access to a financial expert who advises you and initiates ETF trade on your behalf. On the other hand, for experienced traders who wish to cut on fees, then an online discount account for brokerage services. This account enables you to carry out trade all by yourself.
You can also go for the Robo-advisor option. This option is similar to the full-service account. The only difference is that the Robo-advisor is a software instead of a human expert.
Step Two: Decide on the Type of ETF You Want to Trade
There are plenty of options when it comes to ETF types. For example, you can choose an ETF that follows a specified sector, such as energy, fin-tech, or manufacturing. You can also go for ETFs that track a specific index, such as the S&P 500. This aspect of ETF investment can be quite overwhelming, which is why you should research the various ETF types to make an informed decision.
Step Three: Calculate Your Budget
Once you settle on your ideal ETF type, you will need to decide on how much you are willing to invest in the ETF trade. You can employ various strategies to settle on how you want to make your investment. You can either invest in lump-sum or make scheduled investments on a regular basis.
Step Four: Make a Deposit
You cannot initiate trade without a deposit. Some brokers will require you to deposit a minimum amount to activate your account, while some come without this requirement. There several ways through which you can fund your brokerage account. You can send money directly from your savings account or by chequing. Once your brokerage account is funded, you will be set for trade.
Step Five: Initiate Trade
With money in your account, it is now time to make your first purchase. Your decision should be based on research for the right ETFs for your investment. However, when trading ETFs, there are several elements that you must be conversant with, including the following:
Bid Price – This refers to the amount that you are willing to pay for an ETF.
Ask Price – This is the lowest value that an ETF seller is willing to receive.
Quantity – This refers to the number of shares that you want to buy.
Order – This is a set of instructions that restrict how an ETF is purchased. There are two types of orders, including the limit order and market order.
Limit Order – This order specifies the amount of money you are willing to give for an ETF, and trade is only executed when prices fall to this or a lower amount.
Market Order – With this order, the purchase of an ETF is executed at the market price.
ETF Trading Sites/Brokers
In the recent past, the number of brokers entering the ETF space to offer brokerage services has grown significantly. This list highlights examples of the leading ETF brokers.
Charles Schwab offers a wide range of ETFs. The site is also popular for offering some of the lowest costs in the market. Since 2018, the platform has featured up to 245 commission-free Exchange-traded Funds. Schwab also features an ETF Portfolio Builder, a tool that enables you to assemble the right ETFs as per your goals and needs. You also cannot go without noticing the site’s research tools, in addition to a myriad of articles that are related to ETF investments.
This is another leading ETF trading platform, recently acquired by the Charles Schwab company. TD Ameritrade is popular for its wider selection of ETFs, with over 2300 no-commission ETFs. Investors can also enjoy multiple research tools to keep them on top of the game. The Morning Star research featured on the site gives you access to the Net Expense Ratio, current prices, Gross Expense Ratio, and other ratings. If you are looking for an advanced touch of digital experience and high-tech features, then TD Ameritrade is your ideal choice. Investors can use voice commands to make balance enquiries, make orders, and move money.
E-Trade is also a well established brokerage platform when it comes to easy-to-use research and complementary tools. The site is also known for its advanced trading platforms for other securities, including mutual funds and stocks. E-Trade offers some of the best valued ETFs in the industry, with over 250 of these securities trading at zero commission. Features, such as the Knowledge Section, ETFs tracks data, and ETF-related articles, are a reason why E-Trade is a good choice for beginners and experienced traders.
Fidelity is a trading website for both experienced traders and beginners. Fidelity offers trading metrics and other research tools that enhance the investor’s trading experience. The platform also has 100 ETFs trading at zero commission. Fidelity also features advanced trading tools, including the Wealth-Lab Pro and Active Trader Pro, that are designed to enhance the investor’s trading experience. The Wealth Pro, for example, is an option for traders with a minimum balance of $25000 in their accounts, providing unique offers to these investors.
Ally Invest is considerably one of the most underrated brokers when it comes to ETF trading. Although the platform is relatively new, Ally Invest offers a better trading experience than most of the best-rated brokers. This site provides over 100 ETFs at a zero commission, most of which have a high demand. Investors can also enjoy zero-commission ETFs from some of the leading companies, including iShares, GlobalX, and The Vanguard Group.
Risks Associated with ETFs
When investing in ETFs, you should be aware of the following risks and pitfalls;
Index Risk – Generally, ETFs are passive investments that are designed to track a specified index. Since ETFs are traded without active management, investors have put their money against an index. The performance of this index, therefore, is what determines the success of one’s trade. The poor performance of an ETF against the index could result in massive losses.
Tracking Error – This refers to the risk where an ETF fails to match the performance of its designated index. The difference between the returns of an underlying index and those of an ETF portfolio is what reflects the Tracking Error.
Currency Risk – If the assets of an ETF are in a currency that varies from the dominated currency, then you are exposed to what is known as currency risk.
Volatility Risk – Like the stock market, the prices of assets in an ETF are subjected to upward or downward movement on a daily basis. This exposes traders to volatility risk, which can result in huge losses.
Tax Risks – The treatment of tax in an ETF is subject to variation, which has a long-term effect on your investment. In some scenarios also, income tax can be imposed on the returns of an ETF instead of capital gain taxes. Income tax on your returns can have a negative effect on your overall investment.
Types of Metrics to Use When Trading ETFs
Identifying the right ETF for your investment portfolio can be an overwhelming experience, especially when you do not have a place to make a reference. The following are metrics that you can rely on when deciding on the best ETF for your trade.
This is the amount that it will cost you to hold shares in a specified ETF, and it is always given in percentage. For example, if an ETF has an expense ratio of 0.20%, then you will pay $20 for every $10,000 ETF investment.
This is the measure of how an ETF performs in the tracking of its designated index. For example, if an ETF tracking the S&P 500 index with an annual return of 10% achieved 9.9%, then it is said to have performed to the expectations of the investor. A further deviation from the 10% return would display poor performance.
Assets Under Management
This represents the total value of all the assets held in an ETF. This measure is affected by a change in the value of each security, as well as the purchase and sale of assets in the ETF by investors. For example, if the value held in an ETF grows by $10,000, then the AUM of that ETF grows by the same value.
This metric shows where the money of an ETF is invested. This reflects the much exposure an ETF is given to industries, assets, sectors, and regions.
ETFs have become one of the largest asset classes for investors over the past 10 years. ETF liquidity, stable and attractive returns make them an investment traders should consider in their portfolio. There are risks that investors should also consider before deciding whether or not to put their money in ETFs.