Even if you have no prior investing experience, there’s little doubt that you’ve at least heard of exchange-traded funds (ETFs).
ETFs can be valuable investment tools that are useful for all levels of investors. This ranges from billion-dollar money managers to small-level amateur individuals.
They’re used to complement and build well-diversified portfolios. And they're used to leverage short-term trading opportunities.
But to fully benefit from ETFs, investors must first understand them and know how to best use them...
What Is an ETF?
An ETF is an investment vehicle that’s similar in many ways to a traditional mutual fund, like those that are probably in your retirement account.
And like a traditional mutual fund, an ETF holds a pool of investments or tracks an index of commodities, stocks, bonds, and other assets.
For example, the SPDR S&P 500 ETF (NYSE: SPY) tracks the performance of the S&P 500 Index. In other words, when the S&P 500 Index rises, so will the value of SPY. And when the S&P 500 falls, so will SPY.
A commodity ETF, like SPDR Gold Shares (NYSE: GLD), tracks the price of gold by taking and holding the physical metal. So, as the price of gold fluctuates, so will the value of GLD.
Meanwhile, other ETFs, like Global X Copper Miners ETF (NYSE: COPX), track the price and performance of a group of industry-related stocks. COPX tracks the performance of a copper miner index.
The main advantage to all this is, of course, diversity.
You want to invest in oil or artificial intelligence (AI) stocks.
You think that the price of oil- or AI-related stocks are headed higher. But you also want to get better leverage by investing in exploration and production (E&P) and different technology stocks.
You could spend hours, days, or weeks, and rack up a bunch of trading fees, on researching and buying a group of oil E&P and technology stocks individually. And trust me, it's a lot of time, work, and money.
Or you could gain exposure to a group of oil- or AI-related stocks in one fell swoop.
ETFs offer investors an easier and better way to own mutual funds...
What Are the Differences Between Mutual Funds and ETFs?
Relative to mutual funds, ETFs are new. In the 1990s, State Street Global Advisors (SSGA) created the first ETFs in the U.S., also known as SPDRs (spiders).
And today, there are thousands of ETFs. According to ETFGI, an ETF research and consultancy firm, there are over 5,000 ETFs that currently trade globally with over 1,700 based in the U.S.
The most obvious difference between ETFs and traditional mutual funds is that ETFs trade on a stock exchange like any other equity.
They are “exchange traded.” In other words, you can easily buy shares of an ETF from any regular brokerage account. So, you can think of them as easy-to-trade funds.
Owning a traditional mutual fund generally requires you to open an account with the institutional manager. This makes owning ETFs a much cheaper option than owning traditional mutual funds, which can carry heavy fees.
Other major differences include how ETFs are managed. Mutual funds are actively managed. This means there's an individual or group of managers actively changing the components of the fund. ETFs, on the other hand, are generally passively managed. This means that managers follow the same methods as the underlying index.
How to Best Use ETFs
Investors interested in ETFs have many options. And there are also many different strategies investors can use with ETFs that they couldn't use with traditional mutual funds. This includes short selling. Also like stocks, with ETFs, you can place orders: limit orders, good-until-canceled orders, stop-loss orders, etc.
With all advantages considered, ETFs are a great option for investors who want to leverage a short-term market. But for long-term investing, ETFs aren't always the best option.
Like traditional mutual funds, ETFs still have expense fees that can cut into gains. Some ETFs pay dividends, which balance out those expense fees. But those dividends are derived from equity positions that an investor can also individually own.
The short of it is that ETFs are best used as short-term trading tools. And that's particularly true with commodity ETFs, such as GLD...
Most commodity ETFs attempt to track the benchmark's percentage at a 1:1 ratio. Leveraged ETFs usually attempt to track a benchmark at a ratio of 2:1 or 3:1.
That means, for every $1 you've invested, you have $2 or $3 of exposure to the benchmark. This magnifies gains or losses by 200% or 300%.
Leveraged ETFs are possible because of underlying derivative investments. And they often have significant holdings in futures and swaps. But they're much more volatile than normal ETFs and should only be used for short-term trading.
The majority of ETFs are designed to track an index. But you'll quickly learn that they aren't exact duplicates. Tracking errors, differences between returns of an ETF and returns of the index, are common. And this is because of differences in the composition, management fees, expenses, and handling of dividends.
Even ETFs that are designed to track and hold physical commodities often have slight tracking errors. Knowing about these tracking errors before you buy in could clear up a lot of confusion later on.
Like other investments, it's vital to evaluate all the options on the market. If ETF investing interests you, know there are some great online resources with much more in-depth information out there.
ETFDB.com is a great resource for ETF-related information and so is our sister publication WealthDaily.com.