Everything You Need to Know About ETFs (or Exchange Traded Funds)

Benny Ha

By: Benny Ha, June 11, 2021

In this article, you will learn:

  • What is an exchange-traded fund (ETF)
  • What are the different types of ETFs
  • How to invest in ETFs
  • Why you should invest in ETFs
  • How ETFs work
  • The Different Styles of ETFs
  • The Different Sizes of ETFs
  • Pros & Cons of ETFs
  • And More!

This article contains valuable information regarding exchange-traded funds (ETFs) that investors can use.

ETFs can help investors participate in the stock market more easily than by trying to select individual stocks to buy. In addition to adding diversification and reducing volatility to an investor’s stock market portfolio, ETFs also are liquid enough to be  bought and sold when the stock market is open.

This article provides investors with important information to consider before deciding whether or not to invest in or sell shares in such funds.

Everything You Need to Know About ETFs: What is an Exchange-Traded Fund?

ETFs are portfolios of securities that can include stocks or bonds. Such funds are assembled by professional investment fund managers and typically are designed to match the results of a particular stock market index, such as the S&P 500, or selected industries.

By investing in a single ETF, investors have an easy way to enter the stock market and know that their results will very closely match the performance of a particular index or sector. In contrast to buying individual stocks, a single ETF investment automatically better diversifies an investor’s stock market portfolio.

By using that strategy, investors can reap the benefit of owning the shares of an ETF, rather than just buying one individual stock. Given that an ETF is essentially a mix of securities blended into one portfolio, one might think that particular investment is similar to a mutual fund.

While they both are funds, ETFs trade in the stock market throughout the day like individual stocks, unlike mutual funds that only are re-priced at the end of a trading day. There are other differences between exchange-traded funds and mutual funds that will be covered in a separate article.

Everything You Need to Know About ETFs: Types of ETFs

Though there are many asset classes that ETFs can be put into, this article we will focus on the seven: Equity, Bond, Commodity, Currency, Alternative, Multi-Asset and Real Estate.

  • Equity ETFs own a portfolio of shares of publicly traded companies listed on the major stock market exchanges. When someone talks about ETFs, they are most likely referring to equity ETFs.
  • Bond ETFs invest solely in fixed-income securities. This can include all types of bonds, varying from corporate bonds issued by public companies, to Treasuries issued by federal governments, to municipal bonds issued by state governments.
  • Commodity ETFs invest exclusively in physical goods and raw materials. Such commodities include metals and natural resources, among others.
  • Currency ETFs provide investors with exposure to foreign exchange currencies. Investors can use them to capitalize on ongoing changes in the value of the currencies.
  • Alternative ETFs invest in unconventional securities, rather than traditional equities or bonds (e.g. private equity, venture capital, hedge funds, etc.).
  • Multi-Asset ETFs invest in multiple different asset classes. Essentially, the goal of investing in a multi-asset ETF is to allow an investor to buy shares in an ETF to obtain a diversified portfolio of both stocks and bonds.
  • Real Estate ETFs hold baskets of securities exclusively in this sector. By doing so, investors can invest in the real estate industry with one ETF.

Each ETF is essentially a portfolio of stocks. Thus, an ETF offers diversification without requiring an investor to research and buy individual stocks to achieve the same objective. Many investors use ETFs to reduce risk. Similar to mutual funds, ETFs invest in indexes or sectors of the market. Perhaps the biggest difference between mutual funds and ETFs is that the fee for ETFs — if there is one — is usually much smaller than it is for mutual funds. This is one reason why the popularity of ETF investing has grown strongly in recent years.

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Everything You Need to Know About ETFs: Why You Should Invest in ETFs

By reading thus far, key benefits of investing in ETFs should be apparent. The following example shows how ETF investing is superior to individual stock investing

An individual stock can rise 20% overnight, while the market only climbs 5%. Such a stock price surge is great when it happens, but the equity also can crash 20% while the market drops or rises 5%. An individual stock is much more volatile than a portfolio of stocks aggregated together in an ETF. So, relatively new investors may find it safer and less volatile to invest in an ETF than to invest in a higher risk single stock, even after analyzing the equity’s prospects. On top of that, ETFs have lower expense ratios than mutual funds, and investors don’t have to spend nearly as much on commissions as they would if they were to buy  mutual funds instead.

Everything You Need to Know About ETFs: The Different Styles of ETFs

To further break down ETFs, they generally can be split into three styles: Value, Growth and Blend.

  • Value ETFs invest in the stocks of companies that are considered undervalued based upon their current or recent financial performance. The ETFs can be assessed by using fundamental stock analysis. Most of these ETFs hold their value better than growth ETFs in a bear market, but a downside is that they tend to have lower potential for growth. An upside, however, is that they generally have larger dividend yields because value funds consist of companies that produce substantial profits today and are therefore less reliant on future growth for their valuation (e.g., Coca-Cola, ExxonMobil, Bank of America, etc.).
  • Growth ETFs, in contrast to Value ETFs, look to invest in companies that have the potential for high future growth. But the growth ETFs usually are not fully valued by the latest financial results. Therefore, there’s more risk involved when investing in growth ETFs because their performance is more dependent on higher risk future activities than on sustaining existing financial results from proven business operations.
  • Blend ETFs are the most common type. Succinctly, a blend ETF owns both value and growth stocks. This strategy allows the creation of a diversified portfolio that lets investors capitalize on potential future improvement in the performance of the growth stocks, as well as from the dividend income and long-term stability of value stocks.

Image courtesy of https://www.shutterstock.com/

Everything You Need to Know About ETFs: The Different Sizes of ETFs

ETFs typically fit into six size categories. They are Large-Cap, Mega-Cap, Micro-Cap, Small-Cap, Mid-Cap and Multi-Cap. The word “cap” refers to the market capitalization of an ETF. Market capitalization refers to the total value of a company, or more specifically the total value of the shares of an individual stock. The following takes an in-depth view of what size means about an ETF.

  • Large-Cap: These funds invest in companies that have a market capitalization of at least $10 billion.
  • Mega-Cap: These funds invest in companies with a market capitalization of at least $100 billion.
  • Micro-Cap: These funds invest in companies generally valued between $50 million and $300 million. Anything below $50 million is classified as.
  • Small-cap: These funds invest in companies valued between $300 million and $2 billion.
  • Mid-cap: These funds invest in companies worth between $2 billion and $10 billion.
  • Multi-cap: As the name suggests, multi-cap ETFs invest in companies that belong to various market-cap sizes, whether it’s Micro-Cap or Mega-Cap.

There are important facts that must be shared. Large-Cap and Mega-Cap ETFs invest in bigger companies and generally comprise blue-chip companies, which are companies with a history of stable performance and earnings. On the other hand, small-cap ETFs have much more potential for significant growth and development into large-cap ETFs because they invest in companies that are smaller and have more room for growth. Therefore, small-cap ETFs are generally more risky than large-cap ETFs, but like any investment, one should perform research before making any kind of decision because larger doesn’t necessarily mean better.

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Everything You Need to Know About ETFs: Risks

So far, we’ve talked about the most important reasons to invest in ETFs but now it is time to discuss the risks.

Recall the different sizes and styles of ETFs that we covered previously. Though it may seem like all ETFs lead to diversification, some ETFs invest in very specific or narrow asset classes or sectors. For example, a particular ETF may invest exclusively in a specific sector that comprises only large-cap stocks. This could take away an investor’s opportunity to reap the benefits from small-cap or mid-cap companies. In addition, the dividend yields from ETFs may be lower compared to holding high-yielding dividends from individual stocks. Perhaps the biggest downside of an ETF is if an investor decides to invest in leveraged ETFs.

A leveraged ETF uses financial derivatives and debt in an attempt to enhance the returns that otherwise would be produced by an underlying index.

In a nutshell, a double or triple leveraged ETF can dip more than two or three times the index that it’s tracking. If an investor doesn’t act quickly, the losses could be substantial. Thus, tradeoffs exist in investing in ETFs rather than selected stocks.

Everything You Need to Know About ETFs: The Bottom Line

While ETFs have many attractive attributes, it’s still crucial for investors to acknowledge the risks involved when trading them. The size, style, sector and asset class are among some of the key aspects to recognize when investing in ETFs.

Diversification, small expense ratios, low volatility and dividend payouts are  benefits that investors can obtain by using ETFs in their portfolios. However, like any investment, the investor should perform their due diligence by researching a given ETF, monitoring its performance and remaining mindful of its risks.

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