When you’re exploring the stock market as part of the financial literacy process, and ETF, or exchange-traded fund) can be a great investment option for you. They are lost cost, practical, and can be easily bought by entry level type investors as well as people who are more advanced. Learn more on ETFs and how they work below.
Investing and the stock market can be confusing at all the terminology that is out there and thrown around. Stocks, bonds, assets, indexes, and funds are all words that seem almost interchangeable – but they all have distinct meanings, and each type of security has its unique pros and cons. One type of security that is very popular and is even becoming increasingly more popular is the exchange-traded fund, commonly shortened to ETF. Here, you’ll find out exactly what an ETF is and what the benefits of purchasing shares of an ETF could be. It can be even more beneficial type investment now that all brokers offer comission fee trading.
What exactly is an ETF?
An ETF is a conglomeration of many assets, bundled into one distinct fund that trades on the public stock markets in real time. They can be bought and sold throughout the day when the stock markets are open. Any investor can use any broker to buy an ETF as they trade on the public market, so Acorns, Etrade, Fidelity, Robinhood and any company will allow the buying and selling of Exchange Traded Funds throughout the day.
An ETF can contain any proportion of physical goods, commodities, stocks, bonds, or any industry-specific security, so they are in effect of “basket” of securities. This means they can give diversity, which is important in any financial portfolio. Usually, exchange-traded funds track the stock market as a whole – like S&P 500 ETFs, which are funds that directly invest in the companies whose stocks make up the S&P 500 – but some follow specific sectors or industries, like technology, housing, healthcare or agricultural products. Industry-specific ETFs allow investors to still invest in the industries they know without going all-in on a specific company or stock. It also allows investors to distribute their money across multiple assets without having to work as hard, allowing them to purchase a single type of share rather than sink time into searching for many different assets on a stock exchange.
How ETFs operate
Exchange-Traded Funds are operated as (mostly) passively-managed funds, meaning that assets are bought and sold from the fund on a predetermined set of dates every year. The passive management strategy is opposed to the strategy employed at actively-managed mutual funds, which utilize asset managers to buy and sell those assets during the appropriate trading windows each day. Passive management benefits investors, as passively-managed funds do not need to pay asset managers as much of a percentage of revenue as actively-managed funds do. This means the annual expense ratio/management fees are lower, thus lading to more money in your pocket. By pairing this with the fact that investors only need to buy a single type of stock to purchase an ETF, investors can significantly reduce brokerage costs when diversifying their assets.
While reading this, you may think that these funds sound quite a bit like manual funds or hedge funds. While ETFs are certainly structured similarly to these other types of funds, the fact that they are listed on the public stock market makes them unique. The public listing allows them to be bought and sold during the hours that the stock market is open, giving investors a chance to sell their shares at any time during the day rather than just once a day like with mutual funds.
Pros and cons of investing in ETFs
As with any other type of investment, ETFs come with some risks and some benefits. The largest benefit that investing in ETFs is their low cost. The management fees/expense rations are much lower than other forms of investments, such as mutual funds or stocks. An ETF charges (on average) about .4% of its assets vs. mutual funds that average about 1.4% per EF.com. Combine that with zero commissions now offered by stock brokers such as Robinhood, Etrade, and others, it makes ETFs much lower in transaction as well as holding costs. Less costs to buy and sell them means more money in your pocket, and that can be used for your other financial literacy goals like emergency savings. This allows more of your money to grow on a compound basis, which so important to growing the value of your investments. Learn how compound interest works.
Another advantage of Exchange Traded Funds is they provide for the average investors is the convenience of diversification across industries. With a single purchase, investors can gain exposure to an entire sector – whether that’s healthcare, pharmaceuticals, technology, natural resources, or commodities. Larger-scale ETFs can give investors access to emerging markets not in the United States, allowing investors to hedge their bets by investing in rapidly growing markets without risking all of an investment in countries with uncertain stock market regulations.
One of the key aspects of financial literacy is taxes. As tax rates impact how much money is in your pocket each month, and ETFs have lower taxes than mutual funds. This will help you save and invest, as the state and federal government tax authorities will earn less of your investment. It saves a significant money on capital gains as you are not paying those on an annual basis – only when you sell the investment. Learn more on type of income that leads to taxes paid.
ETFs have some downsides as well, though not many. Many industry or sector-specific ETFs have limited selling liquidity on the stock market since the demand isn’t that high. This means it can be more challenging if/when you want to sell the ETF, as you may not get the best price for that sale. Demand is relatively low because many of these ETFs only get interest from the general public when a company in that sector gains publicity, but slowly subside into the background when the market is stable. That said, this is not necessarily a bad thing overall – it just means that investors must be patient when trying to sell shares in some ETFs in order to get the best price, rather than expect the shares to immediately be sold. If you want the flexibility to cash out immediate (such as in a turbulent stock market), ETFs may not be the best option.
Another slight downside to ETFs is the locked-in diversification state. As financial literacy always is about diversification as well so all your “eggs” are not in one basket. Though purchasing shares of an ETF exposes you to a sector or to the stock market as a whole, it does not give you the flexibility to invest more into a specific stock or financial asset – it simply allows you to invest in the predetermined assets already in the fund. Locked in diversification means you can’t change the makeup of the Fund or “tweak it” on an as needed basis. The asset allocation strategies used by different ETFs means investors must carefully study each ETF to understand the distribution of assets present before buying, as that is locked in until the next rebalancing date for that ETF.
Bottom line of Exchange-Traded Funds
Exchange-traded funds are great ways to passively invest in the stock market for both new as well as advanced investors. An ETF can even be better industries and sectors that you know well. While any stock market investing comes with its own inherent risks, that aside, ETFs are low-risk and medium-reward investments, which is great for any financial product.
They are great at allowing you to buy in at a relatively low cost throughout the day and offer lower taxes as well as expense ratios. They also fluctuate in price during the day, letting you trade them as you would any stock – potentially gaining the chance to make significant monetary gains without gambling on standalone companies. Overall, for anyone who is improving their financial literacy and wants to learn more, the take away is that exchange-traded funds are a wise investment to have as at least part of your investment portfolio.
By Jon McNamara