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Everything You Need To Know About Exchange-Traded Funds (ETFs)

Sarah Li Cain5-minute read
June 14, 2022

There are a myriad of ways investors can place their money into different types of markets - think stocks, bonds, index funds and mutual funds. In the past 30 years, ETFs, or exchange traded funds, have risen in popularity, and with good reason. That’s because it offers investors more choices than ever before.

Let’s take a look at what ETFs are, their characteristics and features, why they’re popular and how you can get started investing using this vehicle. 

What Is An ETF?

ETFs are a type of pooled investment fund that allow individual investors to diversify their portfolios by investing in shares of a wide range of investment vehicles. ETFs also allow investors to trade whenever they like, unlike mutual funds, which can only be bought or sold at the end of the trading day.

The reason an ETF is named as such is because the assets within the fund are traded on an exchange, much like stocks (there are also bond ETFs which trade bonds). Plus, the share price of an exchange traded fund changes as they’re bought and sold throughout the trading day on the market.

How Are ETFs Different From Mutual Funds?

When looking at the difference between an ETF vs a mutual fund, it’s important to understand what’s similar about them first. One of the main ways they’re similar is that they’re both pools of investments that offer a specific objective (like growth or investing in a certain industry) and you can buy shares to access a diverse range of investment holdings. Plus, both track predetermined benchmarks.

Now that you know what the similarities are, let’s take a look at some of the main differences.

Exchange-Traded

ETFs can be traded as often as an investor likes or wishes any time the market is open. This means that an investor can react faster to news that affects the market so that they may be able to take advantage of favorable opportunities before the market closes.

As for mutual funds, investors can buy and sell shares of funds when regular trading hours on weekdays close. That means you can put in an order right when the market opens but there won’t be any activity until the end of the day when trading is done.

Since this type of more rigid trading can create a lag in prices from when you place the order to when the market closes, investors may receive different prices for their mutual fund shares. It can also be less attractive since investors may not be able to take advantage of favorable opportunities during the day.

Active Vs Passive Management

Mutual funds tend to be actively managed by fund managers who trade stocks based on their predictions — whether assets in the fund will go up or down. There are notable exceptions, like index funds which passively track widely accepted benchmarks.

Contrast this to exchange traded funds in which the majority are not managed by humans. ETFs started as a type of index fund called SPDRS, tracking the S&P 500 — they’re still tracked using an algorithm that looks at the S&P 500 or the bond market in the U.S.. At the same time it allows exchange trading at will. Although there are newer ETFs offering more active management, most ETFs are still considered passively managed funds.

Net Asset Value (NAV)

The NAV is used to compare different funds and their performance. It’s determined by adding up the value of assets within a specific fund, subtracting liabilities, then dividing it by the number of outstanding shares. It’s used to determine the value of an individual share’s portion of a fund’s assets and cash.

Both ETFs and mutual funds use the NAV, though ETFs calculate it daily after the markets close. During trading hours, an exchange traded fund is based on the market price of the share that can be bought or sold on the exchanges.

Mutual funds, on the other hand, are only based on the NAV and are priced quarterly or annually. Since mutual funds don’t have to disclose their holdings daily, it doesn’t offer the same type of transparency as ETFs do.

Are ETFs Popular Investments?

Like mentioned earlier, ETFs are gaining in popularity, especially among younger investors. Here are a few reasons why.

Variety Of Offerings

ETFs generally offer a wide range of investment options for investors ranging from different types of sectors, commodities, currencies, and location (such as international stocks and bonds). For example, you can purchase ETFs that only track the healthcare industry or that follow the top stocks in certain countries like Germany.

Liquidity

ETFs can be bought and sold much like individual stocks, in real-time during trading hours or right when the market opens. This can be very appealing to investors with limited capital so that they don’t need to wait to sell a losing investment.

Low Fees

ETFs offer lower expense ratios than mutual funds and can even be purchased in commission-free accounts. For investors with limited funds to invest, avoiding fees and commissions can be crucial to amassing wealth.

Keeping Up With Investing Trends

ETFs can be created or formed quickly, meaning you can invest in hot sectors with a short amount of time. ETFs that adhere to environmental, social, and governance (ESG) investing principles are also popular.

Risks Of ETF Investing

Although there are many advantages to ETF investing, there are always risks with any investments.

Market Risk

Market risk is the risk of losing all or part of the funds you’ve invested because of factors affecting financial performance of the market. Investors should do their homework before deciding to invest in any type of asset. Since it’s easy for ETF investors to invest in hot sectors that may involve risks that you may not adequately understand, it’s even more important to do your due diligence.

Tax Risk

Although an ETF can be a more tax-efficient investment vehicle compared to others like mutual funds, there is still a tax risk. Redeeming shares of an ETF may trigger a tax liability (such as paying capital gains tax) so it’s wise to consider whether you want to hold onto a fund for the short or long term.

Exotic Investment Risk

Investors need to be aware of the risks of large scale investing, which ETFs facilitate. Large inflows of cash into underdeveloped economic activity can make large returns elusive, and large outflows when profits don’t materialize can cause losses. In other words, there can be the potential for large swings either direction in the market (depending on the specific fund you invest in). That’s why it’s important to invest in funds and assets that you’ve done your due diligence in.

How Can I Get Started On ETF Investing?

You can get started with ETF investing by downloading one of several highly-rated investment apps. Many don’t require a large minimum investment amount and offer different features, from ones where you can ask for the occasional help to the ability to speak to someone. You can even start investing by signing up for an account online on your mobile phone.

Summary: ETFs Are A Great Way To Start Investing

ETFs are passively managed funds that are one of the most cost-effective ways to invest because of low expense ratios and management fees. It doesn’t require a lot of money to start and there are many low barrier ways to open an investment account. Considering the myriad of funds available, the fact that investors can keep up with investing trends, it’s easy to see why it’s popular.

However, with any type of investment, ETFs also have its downsides, so please do your own due diligence and speak with a licensed financial expert or advisor before making any major financial decisions. Plus, investing can be a great tool for your overall financial plan — check out our learning center to learn more about your personal finances.

Sarah Li Cain

Sarah Li Cain is a freelance personal finance, credit and real estate writer who works with Fintech startups and Fortune 500 financial services companies to educate consumers through her writing. She’s also a candidate for the Accredited Financial Counselor designation and the host of Beyond The Dollar, where she and her guests have deep and honest conversations on how money affects our well-being.