Looking to learn more about ETFs, look no further, this article will explain what ETFs are and elaborate on how they differ from some of their similar counterparts.
ETFs trade identically to individual securities such as AAPL and MSFT; the only difference is that with an ETF, you are not purchasing a single security but rather a basket of securities that provides your portfolio with exposure over a wide range of companies, sectors, and industries.
Some of the benefits of ETFs include:
· Low-Cost Structure
· Diversity & Transparency
· Index Tracking
Unlike Mutual Funds, ETFs never charge a load fee, and their expense ratios are typically much smaller.
Passive, index-based ETFs typically have the lowest fees. An example is the .03% expense ratio of Vanguard’s S&P 500 ETF (VOO). To highlight how small this fee is, you would incur only $71 in fees with a hypothetical investment of $10,000 in VOO over a 10-year period.
Passive ETFs can get away with charging lower fees because there is minimal effort on behalf of the fund manager’s team to ensure they are properly tracking the underlying index. Additionally, passive ETFs make money by loaning out the shares held within the ETF for a fee to investors interested in shorting select companies.
On the other hand, actively managed ETFs will always have higher expense fees than their passive counterparty. Active ETFs must charge higher fees to compensate the fund’s team for the data and research that goes into every investment they make. Additionally, because an actively managed ETF consistently turns over its portfolio in its pursuit of outperforming a benchmark, taxes and fees will also eat away at the overall returns.
One of the more significant advantages of ETFs is the diversity they provide to a portfolio. Instead of owning a single or handful of stocks, ETFs can provide you with access to an entire index with a single purchase.
Additionally, ETFs track all types of indices and investment outcomes, from ESG ETFs that allow you to invest in companies that reflect your values to sector ETFs that enable you to invest only in landscapes you feel most comfortable. With the wide range of ETF investments available, you will undoubtedly be able to find one or many that work best with your investment style.
Finally, unlike mutual funds or money managers, with ETFs, you will always be able to see the underlying equities held by the fund before you invest. You can see the exact weight of each holding and compare these weights with similar ETFs that you are interested in, thereby ensuring that you hold the precise mixture of investments that you desire.
Index tracking, or indexing, is the practice of buying all the components of a market index, such as the Standard & Poor’s 500 Index. An ETF’s ability to perform this investing style may be its most convenient and significant benefit.
While tracking an index and matching its returns may not seem all that exciting or extraordinary, the fact that the average investor (retail or professional) underperforms the market in any given year should make the ability to own the market itself an enticing offering.
Supporting this statement is the fact that picking individual stocks is a zero-sum game as all stocks in an index must be owned by some investor. As a result, 50% of the participants actively trying to outperform the index will fail in any given year, and the other 50% will succeed. Additionally, even those in the 50% who do beat the market’s return, their net return might still be less than the market average after deducting management fees and capital gains taxes, making it even less likely to outperform.
In the end, ETFs allow investors to avoid playing this 50/50 game and while investing in an index tracking ETF such as Vanguard’s S&P 500 ETF (VOO) ensures that you will never beat the market’s return, it also guarantees that you will never join the majority of investors underperforming their benchmark index.
Although both ETFs and Mutual Funds have a similar structure and can create a diverse portfolio, there are many differences between the two.
One of the major differences between ETFs and Mutual Funds is how they are managed. ETFs are primarily passive investments based on the performance of a particular index, whereas Mutual Fund managers are more active in their management style.
Another big difference between ETFs and Mutual Funds is how they are traded. ETFs are traded like a stock and bought and sold on the stock market with price fluctuations throughout the day. Mutual Funds on the other hand, are executed once per day, with investors receiving the same price at the end of the day.
Some other differences to consider between ETFs and Mutual Funds are the costs involved, minimum investment needed, and tax efficiency.
Inverse ETFs are ETFs designed to perform inverse to the benchmark or ETF they track.
For example: If you purchased the Invesco QQQ ETF and it went down 10% in one day, then an inverse ETF tracking QQQ would be up 10%.
Investors may use inverse ETFs to temporarily hedge their portfolio in periods of downturn and vice versa.
Leveraged ETFs use a combination of derivatives and futures contracts to maximize the payoff to their investors and come in different formats, usually -2x and -3x leverage.
Additionally, even Inverse ETFs can come in leverage format. In our example above, if an investor had purchased SQQQ (a 3x inverse leveraged ETF), they would be up 30% when QQQ declined by 10%.
However, this leverage is not a free lunch and comes at a cost to the investor. Compounding returns are lovely when they are in your favor; however, multiple days of negative compounded returns at 3x leverage can put an investor in a hole quickly, and therefore investors should research these types of investments carefully and appreciate the risk/reward payoffs. Additionally, as mentioned before, these leveraged ETFs use derivatives and futures contracts to obtain their investment goals. As a result, even if the market remained flat for a period, an investor invested in these products would lose money as the premium paid for these contracts decays.
As a result of these downsides, most investors only use leveraged products for short-term market views and daily trades & hedges.
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