What are ETFs?
ETF stands for Exchange Traded Fund. ETF is a collection of assets that can include stocks, commodities, or bonds and is traded on an exchange in the same manner as a stock. Investors benefit from low fees and diversification through ETFs because they own a small portion of many different assets, reducing risk.
In addition to lower costs relative to mutual funds, it also has the added benefit of being tax efficient compared to owning individual stocks because it’s unnecessary to sell when receiving dividends.
The first-ever issued ETF was invented by American investment banker and financier State Street Global Advisors in 1993 to track the performance of a specific index or benchmark such as a basket of stocks representing theS& P 500.
ETFs allow investors to quickly diversify their portfolios with an array of different funds because ETFs are tradable and can be sold short or margined. It makes it an excellent tool for long-term and short-term investments, but keep in mind there is a learning curve to make a successful investment with this financial product.
How do they work?
The mechanics behind how ETFs function may seem complicated at first glance, but like most products, they have been made very user-friendly over the years. In simple terms, an individual who would like to buy shares of an ETF will place an order on their brokerage website, which gets picked up by market makers who create new shares until there is enough demand to fill.
Market makers are individuals who manually enter buy and sell orders on the market to match investors who are buying or selling ETFs at any given moment. Market makers are part of what keeps the price of ETFs stable despite significant changes in the value of their underlying assets.
This process happens throughout regular trading hours, but when exchanges close, an additional mechanism determines the official net asset value (NAV), which gives every investor owning shares during this period a fair valuation.
How to enter orders?
Entering orders can be done through your online discount broker or more sophisticated algorithmic trading systems run by institutional investors and hedge funds. These automatic systems possess many advantages over active managers because they have the nearly complete financial information and can make decisions at blistering speed.
In either case, the process of buying or selling ETFs is not that different from placing regular orders to buy or sell stocks. There are dedicated options for institutional investors and retail traders alike through investment platforms such as Fidelity, TD Ameritrade, E*TRADE, and more.
What risks do I need to be aware of?
Although great tools for long term investments due to their low fees and tax efficiency, it’s essential to keep in mind that ETFs also possess drawbacks that must be considered before deciding whether they’re suitable for you. Anyone should determine when thinking about buying an ETF is what they hope to gain from the financial product.
Are ETFs risk-free?
ETFs are not risk-free; even ones that track the performance of indexes will deviate slightly over time because there is always a chance of corporate action or something else shifting its composition. This deviation between what ETF investors expect and their actual returns is called a tracking error.
Another factor to consider is how long you plan on holding an ETF because they are only as good as the underlying assets that make them up. If your investments are meant to be held for multiple years, this would not be an issue, but if you only want it to provide liquidity for a single day, you must also consider how it will affect you when selling.
Where can I find more information?
Before trading ETFs, the first thing anyone should do is research whether or not they are suitable for you; individual investors have many options at their disposal that can help them see if an ETF might be good to add to their portfolio.