What are Exchange Traded Funds, How to Invest in Them

Exchange-traded funds (ETF) are vital to the modern retail investing landscape, offering traders like you flexibility, cost-efficiency, and diversification. Through these investment vehicles, you can access a wide array of assets like stocks, bonds, commodities, and even emerging sectors like cryptocurrency, all within a single fund. 

What makes them so interesting? Well, ETFs have both the affordability and liquidity that appeal to today's retail investors. The growing variety of ETFs, from index-tracking funds to thematic and sector-specific options, allows you to curate your portfolios to align with your personal investment strategy and outlook. 

This versatility makes them an appealing choice for both newbie and experienced investors looking to optimize their returns and manage risk in a dynamic market environment. In this article, our experts at Arincen will give you the lowdown on how to invest in ETFs.

What are ETFs?

ETFs are investment funds traded on stock exchanges, much like stocks, providing you with liquidity and the ability to buy and sell shares throughout the trading day at market prices. They differ from mutual funds, which are only priced at the end of the trading day. 

ETFs are often less expensive than mutual funds due to their passive management style, as many track an index rather than being actively managed by a human expert. Additionally, ETFs are highly transparent, with their updated value and make-up typically disclosed daily. These attributes collectively make ETFs a versatile and attractive option for diverse investment strategies.

There are many types of ETFs, but at their heart, these financial assets offer a way to pool your money in a fund that invests in stocks, bonds, and even cryptocurrencies. In return, you will receive payouts when you sell your stake in that investment if you sell at a higher price than when you bought it.

You can buy and sell ETF shares throughout the trading day at market price, potentially capitalizing on short-term price fluctuations. This makes ETFs a great option for a wide range of investment strategies, from conservative to aggressive.

How ETFs Work

ETFs are complex yet efficient systems designed to facilitate trading and investment. At its core, an ETF is an investment vehicle that holds a basket of assets, such as stocks, bonds, or commodities, and issues shares representing a fractional ownership of these assets. 

These shares are traded on stock exchanges, allowing you to buy and sell them throughout the trading day at market prices. The price of ETF shares is closely aligned with the net asset value (NAV) of the underlying assets.

This creation and redemption process is important to how ETFs operate. Large financial institutions like banks or even trading brokers create new shares by purchasing the underlying assets in the ETF's portfolio and delivering them to the ETF issuer in exchange for new shares when there is a demand for more ETF shares. This process is known as "creation." 

On the other hand, if there are too many ETF shares in the market, institutions can redeem shares by returning them to the issuer in exchange for the underlying assets. This "redemption" process helps to keep the supply of ETF shares aligned with market demand. 

Although not the main focus of this article, we can confirm that ETFs are known for their tax efficiency. In brief, it’s down to their creation and redemption process that minimizes the capital gains distributions that you might otherwise incur with mutual funds.

In fact, when compared to mutual funds, ETFs offer significant trading flexibility. While mutual funds can only be bought or sold at the end of the trading day at the closing NAV, ETFs trade on stock exchanges just like individual stocks, allowing for intraday trading. This means you can take advantage of market movements throughout the day while using various trading strategies such as limit orders, stop orders, and margin trading.

Types of ETFs

There are many types of ETFs. Here are some of the most common:

Passive ETFs 

Passive ETFs are designed to mirror the performance of a specific index. These Index-Tracking ETFs hold the same securities as their benchmark index, such as the S&P 500, in the same proportions. They offer you a way to gain broad market exposure with low management fees. With sector-specific ETFs, you can focus on particular segments of the economy like technology, healthcare, or finance, allowing you to target specific industries you believe will outperform. 

As you become a more active ETF investor, you will hear the term “thematic ETFs,” which go a step further by focusing on broader investment themes like clean energy, artificial intelligence, or social responsibility, allowing you to capitalize on emerging trends and societal shifts. But, back to the “passive” in passive ETFs - it simply means that when you invest in such an ETF, you can watch the performance of the entire index and not worry about the minute swings of individual assets.

Actively Managed ETFs  

Unlike passive ETFs, actively managed ETFs are overseen by professional managers who make tactical decisions about the portfolio's composition to outperform the market. With these types of funds, you typically need to pay more in fees because of the active nature of how the fund is managed. In saying that, the main advantage of actively managed ETFs is their potential to generate higher returns through strategic asset selection and market timing. 

Bond ETFs 

Bond ETFs expose you to various types of bonds, offering you a way to diversify your income streams. One of the main types of bonds is government bond ETFs that invest in sovereign debt and are typically considered low-risk investments. Corporate Bond ETFs focus on debt issued by companies, offering higher yields but with increased risk. Municipal Bond ETFs invest in bonds issued by local governments, which often provide tax-exempt income, making them attractive to investors in higher tax brackets.

Commodity ETFs  

Commodity ETFs expose you to physical commodities without the need to purchase and store the actual commodities. Precious Metals ETFs invest in metals like gold and silver, which are often seen as safe-haven assets during times of economic uncertainty. Energy Commodity ETFs focus on resources like oil and natural gas and oil, providing a way to hedge against energy price fluctuations and inflation.

Currency ETFs  

Currency ETFs allow you to invest in foreign currencies without the complexities of trading in the FOREX market. Major Currency Pairs ETFs focus on widely traded currency pairs such as EUR/USD or USD/JPY, offering liquidity and stability. Emerging Market Currencies ETFs invest in currencies from developing countries, providing higher growth potential but also greater volatility and risk.

Crypto ETFs  

We’ve discussed these in another article. Crypto ETFs are a recent innovation that provides exposure to cryptocurrencies. Bitcoin ETFs track the price of Bitcoin, offering a way to invest in the leading cryptocurrency without the need to manage digital wallets. Other Cryptocurrency ETFs invest in a basket of various digital assets, allowing for diversification within the volatile crypto market.

Why Invest in ETFs?

So, what’s all the buzz about ETFs? Here are some of the best reasons to invest in them:

Diversification

ETFs typically hold a wide range of assets within a specific index, sector, or theme, providing broad exposure and reducing the risk of investing in a single security. For example, the SPDR S&P 500 ETF (SPY) includes 500 of the largest U.S. companies, offering instant diversification across various industries. This diversification helps you mitigate risks and enhance the stability of investment portfolios.

Cost-efficiency 

This is another significant advantage of ETFs. They generally have lower expense ratios than mutual funds because they are often passively managed. This lower cost structure translates into higher net returns for you over the long term. For instance, the Vanguard Total Stock Market ETF (VTI) has an expense ratio of just 0.03%, making it an extremely cost-effective way to gain exposure to the entire U.S. stock market.

Liquidity and flexibility

These further enhance the appeal of ETFs. Since they are traded on major stock exchanges, ETFs can be bought and sold at market prices, similar to stocks throughout the trading day. This intraday trading capability allows investors to react quickly to market movements and implement various trading strategies. In contrast, mutual funds are only priced once daily at the closing NAV, limiting trading flexibility.

Finally, ETFs cater to a wide range of investment strategies and goals, from: 

• passive index tracking 

• actively managed funds 

• sector-specific investments 

• thematic investing 

• bonds 

• commodities 

• currencies 

• cryptocurrencies 

This versatility makes ETFs suitable for all types of investors, whether looking for growth, income, or hedging against market volatility.

Pros and Cons of ETFs

There are many reasons to go with ETFs, but in saying, there are some elements of which you need to watch very aware:

Pros

Diversification

We’ve already mentioned this, but we’ll say it again. ETFs provide instant diversification by holding a basket of securities within a single fund. This can include assets such as stocks, bonds, or commodities across various sectors and geographic regions. Diversification helps reduce the risk of a single security’s poor performance significantly impacting the overall investment.

Lower Costs

Due to their passive management style, ETFs typically have lower expense ratios than mutual funds. This cost efficiency is crucial for long-term investors, as it results in higher net returns over time. 

Trading Flexibility 

ETFs are traded on major stock exchanges, allowing investors to buy and sell shares at market prices throughout the trading day. This intraday trading provides flexibility to react to market movements and implement various trading strategies. 

Tax Efficiency 

The unique creation and redemption process of ETFs helps minimize capital gains distributions, making them more tax-efficient than mutual funds. 

Cons

Potential Lack of Liquidity 

While many ETFs are highly liquid, some, particularly those that are niche or have low trading volumes, can suffer from a lack of liquidity. This can result in wider bid-ask spreads and make it more challenging to execute large trades without affecting the market price.

Higher Fees for Actively Managed ETFs

Due to the costs associated with active portfolio management, actively managed ETFs have higher expense ratios than passive ETFs. 

Risks Associated with Leveraged and Inverse ETFs 

Leveraged and inverse ETFs use financial derivatives to amplify returns or provide inverse returns relative to an index. These ETFs are designed for short-term trading and can be highly volatile and risky. Their complex structure and daily reset feature can lead to significant losses if you hold them for longer.

Comparison with Other Investment Vehicles

You might be thinking about how ETFs stack up against other types of investment assets. Here’s some important information:

ETFs vs. Mutual Funds

Management Styles (Active vs. Passive) 

ETFs and mutual funds can both be actively or passively managed. However, ETFs are predominantly passive, tracking indices like the S&P 500, offering lower fees and simplicity. On the other hand, mutual funds are more commonly actively managed, and therefore more expensive, even if they can sometimes yield higher returns.

Fee Structures 

Generally, ETFs have lower expense ratios compared to mutual funds. For example, the average expense ratio for ETFs can be as low as 0.03%, while mutual funds might range from 0.5% to 2%.

Tax Implications 

ETFs are more tax-efficient than mutual funds, which frequently buy and sell securities within the fund, generating capital gains that are distributed to investors, who must then pay taxes on them.

Liquidity and Trading Flexibility

ETFs trade on stock exchanges, allowing for intraday trading at market prices, providing flexibility similar to stocks. Investors can buy and sell ETF shares throughout the trading day. Mutual funds, however, are priced only once at the end of the trading day, limiting their liquidity and flexibility.

ETFs vs. Stocks

Diversification Benefits 

ETFs offer instant diversification by holding a basket of securities, reducing the risk of investing in a single stock. For example, buying an ETF like tSPY provides exposure to 500 different companies, whereas investing in a single stock ties you into that stock’s performance.

Risk Management 

ETFs spread risk across many assets, reducing the impact of any security’s poor performance on the overall portfolio. Stocks, however, come with higher specific risks since your fortunes are tied to one company's performance, upsetting your risk management strategies.

Trading and Ownership Differences 

Both ETFs and stocks are traded on exchanges, providing intraday trading opportunities. However, owning ETFs means holding a share of a fund that contains multiple assets, whereas owning stock means holding equity in a single company. ETFs are known to be generally less volatile.

Popular ETFs and Their Performance

Whilethere are many more ETFs out there, here is a snapshot of three you could consider:

SPY

SPY is one of the world's most well-known and heavily traded ETFs. Launched in 1993, SPY aims to track the performance of the S&P 500 Index, which includes 500 of the largest publicly traded companies in the U.S. As of mid-2024, SPY has an expense ratio of 0.09%, making it a cost-effective way for investors to gain exposure to the U.S. stock market. Over the past decade, SPY has delivered an average annual return of around 13.9%, which is pretty good as a passive investment.

iShares Russell 2000 (IWM)

The iShares Russell 2000 ETF (IWM) exposes small-cap U.S. stocks by tracking the Russell 2000 Index, which comprises the smallest 2,000 companies in the Russell 3000 Index. This ETF offers investors a way to diversify their portfolios by including smaller companies, which often have higher growth potential compared to large-cap stocks. Over the past decade, IWM has achieved an average annual return of approximately 10.7%, with an expense ratio of 0.19%.

Bitcoin ETFs

Bitcoin ETFs have emerged as a popular way to invest in the cryptocurrency market without the complexities of owning and storing digital assets. The ProShares Bitcoin Strategy ETF (BITO) was the first Bitcoin ETF approved in the U.S., offering exposure to future contracts for Bitcoin. Since its launch in October 2021, BITO has provided a means for investors to participate in Bitcoin's price movements through a regulated investment vehicle.

How to Invest in ETFs

Steps to Buy and Sell ETFs

1. Open a Brokerage Account: To invest in ETFs, you will need a brokerage account. If you don’t already have one, select a broker that suits your needs and complete the account opening process. This typically involves providing personal information, linking a bank account, and possibly answering questions about your investment experience and goals.

2. Fund Your Account: Once your brokerage account is set up, transfer funds into the account. This can usually be done via bank transfer, wire transfer, or online wallet.

3. Choose Your ETFs: Use your broker’s platform to research the best ETFs. Look at such factors as the fund’s expense ratio, historical performance, underlying index, and assets. Decide which ETFs align with your investment goals.

4. Place an Order: To buy an ETF, enter the ticker symbol into your brokerage platform, specify the number of shares or the amount you want to invest, and place your order!

5. Monitor Your Investments: After purchasing ETFs, monitor their performance regularly and adjust your portfolio as needed to stay aligned with your investment strategy.

6. Sell When Needed: When you decide to sell an ETF, enter the sell order in your brokerage account. Like buying, you can choose a market order to sell at the current price or a limit order to sell at a specific price.

Selecting a Broker

Choosing the right broker is crucial for ETF investing. Consider the following factors:

Fees and Commissions: Look for brokers with low or no trading fees for ETFs. Some brokers, like Charles Schwab, Fidelity, and Vanguard, offer commission-free ETF trading.

Platform Usability: Ensure the brokerage platform is user-friendly and provides the tools and resources you need for effective trading and research. Read our article here for a range of FOREX brokers who normally provide access to ETFs, too.

Customer Support: Reliable customer service can be important, especially if you encounter issues or have questions about your account or trades.

Research and Education: Brokers that provide comprehensive research tools, educational resources, and access to market analysis can help you make informed investment decisions.

Utilizing ETF Screening Tools

ETF screening tools are valuable for narrowing down the vast array of available ETFs to those that meet your specific criteria. These tools allow you to filter ETFs based on various factors, such as:

• Expense ratios

• Performance

• Sector and asset class

• Holdings, i.e., the underlying holdings

Role of Robo-Advisors in ETF Investments

You might be interested in robo-advisors, which have simplified ETF investing by offering automated portfolio management based on your financial goals and risk tolerance. They use algorithms to build and manage a diversified portfolio of ETFs, rebalancing as necessary to maintain your desired asset allocation. Some benefits of using robo-advisors include:

• Low fees

• Accessibility to a professionally managed portfolio

• Customization

ETF Costs and Fees

Investing in ETFs comes with various costs and fees that can impact your overall returns. Understanding these expenses is crucial for making informed investment decisions.

Expense Ratios 

We’ve mentioned this throughout the article as we believe it is a major part of choosing which ETF works for you. The expense ratio is an annual fee expressed as a percentage of the fund's average assets under management. It covers the ETF's costs, including administrative expenses, management fees, and other operational costs. For example, if an ETF has an expense ratio of 0.10%, you will pay $10 annually for every $10,000 invested. So, a low expense ratio like 0.03% would see you pay $3 for every $10,000 invested.

Trading Commissions 

When buying or selling ETFs, you may incur trading commissions charged by your brokerage. These fees can vary significantly between brokers. Be sure to choose wisely.

Bid/Ask Spreads and Premiums

The bid/ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). This spread is usually narrow for ETFs with high liquidity, often just a few cents. However, for less liquid ETFs, the spread can be wider, increasing the cost of trading.

Other Hidden Costs

Beyond the visible costs, there are other hidden expenses to consider. For instance, ETFs that invest in international securities may incur foreign tax expenses or higher custody fees. You should be alert to the fine print when you sign up for any ETF.

Market Trends and Future of ETFs

ETFs are going nowhere and will continue to go from strength to strength. 

Growth in ETF Assets Under Management

The ETF industry has experienced remarkable growth over the past decade. As of 2024, global ETF assets under management have surpassed $10 trillion, reflecting a compound annual growth rate (CAGR) of over 20% since 2010! 

This growth is driven by increasing investor preference for low-cost, diversified investment products and the growth of ETFs across various asset classes and sectors.

Emerging Trends in ETF Strategies and Products

Several emerging trends are shaping the future of ETFs. One prominent trend is the rise of thematic and Environmental, Social, and Governance (ESG) ETFs. Investors are increasingly looking for products that align with their values and long-term themes, such as clean energy, technology innovation, and social responsibility. 

Regulatory Developments and Their Impact

Regulatory changes play a critical role in the evolution of the ETF market. In recent years, U.S. and European regulators have taken steps to enhance transparency and protect investors. The introduction of the ETF Rule (Rule 6c-11) by the U.S. Securities and Exchange Commission (SEC) in 2019 streamlined the process for launching new ETFs, reducing the regulatory burden and encouraging innovation. This rule has made it easier for issuers to bring new products to market and has likely contributed to the growth in ETF offerings.

In Europe, regulatory initiatives such as the Markets in Financial Instruments Directive II (MiFID II) have increased ETF trading transparency and improved retail investors' access to ETFs. These regulations aim to provide greater investor protection and ensure that ETFs are traded efficiently on exchanges. The future of ETFs looks promising, with continuous innovation in product offerings and strategies. It could be the perfect investment vehicle for you if you can find a good broker through thorough research.

Conclusion

ETFs have revolutionized retail investing by offering a blend of affordability, liquidity, and diversification. You can access a wide range of assets, including stocks, bonds, and commodities, within a single fund. Traded like stocks, ETFs allow for intraday trading, which provides flexibility and the ability to react quickly to market movements. Their lower expense ratios, due to passive management, lead to better net returns over time.

The variety of ETFs, from index-tracking funds to sector-specific and thematic options, caters to diverse investment strategies. This versatility means you can find a way to invest in them, whether you are a novice or a seasoned investor. The continuous innovation in the ETF market and regulatory support enhancing transparency make ETFs a resilient and appealing choice.