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What is an ETF?

Updated on 23 Feb 2020

How many times have you asked yourself what is an ETF? ETFs or Exchange Traded Funds is an equity investment tool traded on global exchanges, just like stocks. Let’s understand more about ETFs, and how they can add value to your portfolio.

Introduction
What are the advantages of ETFs?
Diversification
Trades just like stocks
Lower fees
Immediately reinvested dividends
Limited tax on capital gains
Lower premiums
Picking the Right ETF

Introduction

An Exchange Traded Fund (ETF) is an investment product that tracks the performance of an underlying index. They are often explained as baskets that hold stocks or bonds and they trade in the same way that regular stocks do. Their aim is to match the underlying index they track. For instance, if an ETF tracks the performance of S&P 500, it aims to offer the same kinds of returns to its investors as the S&P 500 does. This makes them ideal for investors who want a passive strategy when it comes to their wealth management. As there are hosts of ETFs available in the market, this financial instrument can arguably be used to appeal to investors with different risk appetites quite easily.

ETFs were conceptualized in 2003, and since then, they’ve seen a huge surge in popularity. They are perfect for investors who are looking for viable alternatives to mutual funds, and are known for having lower expense ratios, and better intra day price visibility when compared with their MF counterparts. As they hold an entire basket of stocks and bonds, they offer high possibilities of diversification for investors. They are lauded for being low risk investments as they also come with lower costs.

What are the advantages of ETFs?

When compared with mutual funds, ETFs offer a whole range of advantages that help set them apart from other instruments. Some of these advantages are as follows:

1. Diversification: A single ETF can help you gain exposure to an entire market segment, equities or even styles. ETFs can also increase your portfolio’s diversification as they track a much broader range of stocks or can even mimic the overall performance of a country or a group of different countries.

2. Trades just like stocks: One of the things that make ETFs so popular with investors is that they offer the liquidity of a stock. They can easily be purchase on margin or even sold short. The prices for ETFs are updated all throughout the day, and they can be traded at any given time. On the other hand, when you look at mutual funds, the prices are only posted at the end of the day when the market closes, which offers a lower level of transparency for investors looking to buy the same. Finally, ETFs also help investors manage the degree of risk they are exposed to as they allow them to trade futures and options the same way one would do with stocks.

3. Lower fees: ETFs are managed passively, which is what contributes to the fact that they have much lower expense ratios when compared with mutual funds, which are managed actively by fund managers and financial experts. When you invest in a mutual fund, you must also pay additional costs such as management fees, service fees for marketing, load fees for distributions or sales, and expenses for shareholder accounting at the fund level. The lack of these make ETFs far more accessible to newer or younger investors looking to grow their wealth.

4. Immediately reinvested dividends: When you invest in an open-ended ETF, you’ll find that the dividends are immediately reinvested. When it comes to mutual funds, though dividends are reinvested, there is no exact timing set for when this must be done. The only exception to this rule is dividends related to unit investment trust ETFs – there is a dividend drag to be expected here as they are not immediately reinvested.

5. Limited tax on capital gains: Many investors foray into the world of investments solely because they want to save on their taxes. As a result, they end up looking for mutual funds as they are known to help with the same. However, it may surprise you to know that ETFs are far more tax efficient when compared with mutual funds. There are fewer capital gains taxes involved. Additionally, when you sell or buy ETFs, there are no taxes added onto the final investment.

6. Lower premiums: ETF share prices are rarely higher or lower than their actual value. This financial instrument trades any time during the day and mimics the price of the underlying asset. Even if the price is lower or high than the NAV, arbitrage brings it back in line. ETFs typically trade on the basis of supply and demand, which means market makers catch any discrepancies in the price point.

Picking the Right ETF

Many factors come into play when picking the right ETF. You must evaluate the historical performance of the fund, understand your risk appetite, identify your investment goals, and even be savvy about market trends to the point where you know which industries are worth your while, and which ones are on the decline. This means a ton of research! Let our experts help you out instead. Get in touch with Kristal AI for the best AI-enabled recommendations on the ETFs you should be investing in!

Disclaimer

The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.

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