What Are ETF, Exchange Traded Fund? Advantages and Disadvantages

An ETF is an exchange traded fund which is a cross between a mutual fund and a stock. It combines the stability of mutual funds with the ease of trading that stocks allow. They often contain securities like stocks and track an index. One of the most known ETFs is the SPDR S&P 500, which tracks the S&P 500.

An ETF is a collection of securities that can be traded like stocks, unlike mutual funds that can only be traded once a day. ETFs could contain things like bonds, commodities, or stocks. Some ETFS contain only US holdings, and others have international holdings. ETFs attract fewer costs than buying the contained stocks individually.

An ETF is great for diversification because they hold multiple assets and sometimes multiple asset types, like a mutual fund. However, unlike a mutual fund, they are more liquid than stocks because they can be traded throughout the day.

The Different Types of ETFs

The types of ETFs are categorized by the types of securities they hold. The type an investor picks will depend on their reasons for investing. The following are some examples of ETF types:

Industry ETFs – these track a specific industry and contain a number of commodities in the industry such as banking, oil, technology, and gas.
Commodity ETFs – these ETFs track a particular commodity like gold or crude oil.
Currency ETFs – these ETFs trade in foreign currencies.
Inverse ETFs – these ETFs profit from shorting stocks. However, most of these are not ETFs, but ETNs or exchange traded notes. These are often backed by issuers such as banks.

How to Buy and Sell ETFs

ETFs are traded through traditional and online brokers. You can buy and sell them in similar ways to stocks.

ETF Examples

iShares Russell 2000 (IWM)
SPDR S&P 500 (SPY)
Invesco QQQ (QQQ)
SPDR Gold Shares (GLD)
iShares Silver Trust (SLV)
SPDR Dow Jones Industrial Average (DIA)

What Are the Advantages and Disadvantages of ETFs

Investing in an ETF that holds a number of stocks is more cost-effective than buying all the stocks individually and paying transactions fees each time. When purchasing individual stocks, investors pay transaction fees and broker commissions. Here are some of the other pros and cons of investing in ETFs:

Pros

- There are ETFs with many different stocks in many different industries
- Reduced cost
- Easy to diversify
- Investors can purchase industry-specific ETFs

Cons

- Managed ETFs attract management fees
- Single industry ETFs limit the possibility of diversification
- It is not easy to dump a certain stock held in an ETF

Managed ETFs

A managed ETF allows investors to take advantage of short-term market fluctuations by having a portfolio manager handle their portfolio. These will attract management fees.

Indexed Stock ETF

An indexed stock ETF follows an index fund and therefore allows some diversification. Some focus on one particular industry while others diversify across a number of industries. The advantage of an index stock ETF is there are no minimum purchase requirements. Investors can also buy on margin or short sell ETFs.

Do ETFs Pay Dividends?

Yes, ETFs that invest in dividend-paying stocks will pass the dividends onto the investor. A dividend is a percentage of the stock price which is paid to the investor on a regular basis as “interest.”

Taxes and ETFs

ETFs are tax-efficient in comparison to mutual funds or stocks. Because the ETF does not need to issue or sell shares each time an investor makes a transaction, they don’t trigger a tax liability.

The Market Impact of ETFs

Now that ETFs are a popular investment, there has been an influx of new ETFs. This has raised concerns over whether they can create fragile bubbles as stock values increase due to ETF investment. Some of the portfolio models for ETFs have not been tested in various market conditions so it is unsure how they will perform in an unstable market. It is believed ETFs were a root cause of some of the last decade’s flash crashes.

The Creation and Redemption of ETFs

The process of creating and redeeming ETF shares follow the demand of the market. These moves are made in order to adjust the ETF NAV back in line with that of the shares it holds.

Creation

Creation is the process of issuing additional shares of an ETF. The Authorized Participant (AP) will buy shares of the index and sells them to the ETF. The ETF then issues the equivalent value in shares. Then the AP will sell the ETF shares to the market.

Creation for Premium Shares

An ETF’s value per share is measured by the NAV or net asset value. If the share’s NAV is below the price of the share it is investing in, it is said to be trading at a premium. The AP must bring the share price back into balance with the ETF’s NAV. They can do this by increasing the number of ETF shares on the stock market.

Redemption

Just like an AP buys shares of the stock the ETF tracks and sells them to the fund in exchange for an ETF fund, so too do they buy shares of the ETF in exchange for shares in the individual stock. This process is called redemption.

Redemption For Discount Shares

If the share’s NAV is less than the value of the shares they are holding, then it is said to be trading at a discount. In order to get the NAV back in line with the share price, the AP will buy shares of the ETF and sell it back to the fund in exchange for the shares they hold. This should bring the NAV back in line with the price of the shares.

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