Financial Literacy
Everything You Need To Know About ETFs
Learning about investments can be a challenge, especially when it comes to the stock market. Here in this article, we explain to you what Exchange-Traded Funds (ETFs) are all about and how it can be a wonderful investment tool for your future.
What Are ETFs?
To make it more relatable, trading on the stock market is like cooking. Just like how there are many different food dishes one can make, there are many stocks to trade on the stock market. For some, it can be very difficult to cook from scratch. Similarly, it can be difficult to trade individual stocks. Enter the ETF, an investment fund that lets you buy a large basket of individual stocks or government and corporate bonds in one purchase. ETFs are tailored to follow a particular strategy or philosophy. Think of ETFs like prepackaged meals; they contain the ingredients to make a dish yummy, and you didn’t personally have to do anything to it. If you don’t want to spend time figuring out the best way to build and manage your own investments one by one, you may find ETFs to do quite well at managing your portfolio on your behalf.
Isn't This Just A Mutual Fund?
ETFs are very similar to mutual funds, which is another way to purchase many stocks at one time. But there are a few major differences between ETFs and mutual funds:
- Mutual funds are priced just once a day while ETFs can be bought and sold during the entire trading day just like individual stocks. This explains why they’re called “exchange traded” funds.
- Mutual funds tend to have human mutual fund managers who actively trade stocks in and out of the fund based on which ones they predict will go up or down, while the vast majority of ETFs are unmanaged by humans. ETFs typically follow an algorithm that track an entire economic sector or index, like the S&P 500 or the US bond market. For this reason, mutual funds are generally referred to as being “actively managed” and ETFs “passively managed,” though there are many exceptions to this rule.
- ETFs tend to come with lower management expense ratios (MERs) than mutual funds. MERs, represent the percentage of the value of the entire fund that is deducted annually to cover the fund’s operating expenses. In other words, they’re a management fee. This is because most ETFs don’t require humans to make trading decisions. Since computers work cheap and humans don’t, it’s not unusual for a mutual fund to charge a 1% or higher annual MER and ETFs are usually between 0.05% and 0.25%. As such, ETFs are often considered a low-cost alternative for investors on a budget. Though these numbers may all appear pretty small, a fee or 1-2% can substantially erode investment gains over the long term.
Why Should I Choose ETFs over Actively Managed Funds?
In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons. According to Morningstar’s performance report on active funds vs passive funds over a 10 year period (2009-2019), they found that only 23% of active managers were able to outperform their passive peers who rely on index funds and ETFs. They concluded that investors generally have fared better by investing in low-cost index funds or ETFs.
Different Categories of ETFs
ETFs can be broken down into 5 major categories.
Stock Market Tracking ETFs – These ETFs are also known as as index ETFs or bond ETFs, since they track a particular market index. SPY is an ETF that seeks to mirror the S&P500, an index of the 500 largest publicly traded American companies.
Sector Tracking ETFs – These ETFs focus on a particular sector of the economy, rather than the entirety of it. VGT is an ETF that seeks to track the performance of a benchmark index that measures the investment return of stocks in the information technology sector.
International ETFs – These ETFs can track markets of other countries, whether they have well established economies or are from emerging markets. EFA is an ETF that track investment results of an index composed of developed markets outside of U.S and Canada.
Thematic ETFs – These ETFs are geared towards investing in companies that meet a specific theme. For example, ARKK is an ETF that invests in companies that will cause disruptive innovation.
Complex ETFs – There are number of more complicated ETFs, such as leveraged ETFs and inverse ETFs. Unless you absolutely know what you’re doing, you should avoid these ETFs.
How Can I Trade ETFs?
ETFs are similar to individual stocks, in that they can be bought and sold on the stock exchanges by searching up their ticker symbol. As such, they can be found right alongside public companies, such as Amazon (AMZN) and Costco (COST).
What Should I do Next?
The best time to invest is yesterday, the second best time to invest is today. We advise you to speak to a professional financial planner about ETFs and how to get active in your retirement and savings plan. A little effort now goes a long way.
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