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Should You Invest Into Exchange Traded Funds?

Everything you need to know about Exchange Traded Funds.

Exchange-traded funds (ETFs) are a great investment option for income investors who are living off their investments or for passive investors who aim to save for retirement. Their low costs and tax effectiveness ensure returns close to the tracked index. At the same time risk is kept low by investing into a diversified portfolio of assets.

This post dives deeper into the most commonly asked questions about ETFs and explains their pros and cons.

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What Is A Exchange Traded Fund?

Like company shares exchange-traded funds (ETF) are being traded on a stock market exchange, such as the New York Stock Exchange or NASDAQ. However unlike regular company shares an ETF does not consist of a single stock.

Instead they track a wide spectrum of assets which are being bundled in the ETF based on predefined rules. Most ETFs either track a market index, market sector, trend or theme, commodity, bond or currency. By investing into the ETF based on a fixed set of rules the costs of the fund stay low which makes ETFs very cost and tax-efficient investments.

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What Types Of ETFs Exist?

Market Indices

A market index is a representation of a subset of the whole stock market. It includes stocks based on specified criteria, for example based on the value of a company or the regions in which the company is active.

Many popular ETFs track market indices as they allow the owners of an ETF to benefit from the overall performance of all included securities. At the same time it reduces risk through a high degree of diversification.

A commonly tracked market index is the Standard and Poor's 500 (S&P 500). It tracks and includes the 500 biggest companies which are traded on American stock exchanges. The average return of the S&P 500 has been between 10-11% between 1871 and 2021. The yield offers investors a good base for compound growth while being diversified into the 500 largest companies.

Another popular market index is the MSCI World index. It includes large and mid-cap companies within 23 developed nations. As it covers companies in more countries it reflects the development of the global ecomony while the S&P 500 is indicative of development of the US economy.

Market Sectors & Industries

Market sectors are business areas in which companies perform similar business activities. Common market sectors are the energy production sector, telecommunications sector, transportation sector or information technology sector. Investing into market sector ETFs allows investors to focus on specific industries without having to predict future winners and losers.

While some ETFs focus on market indices or sectors thematic ETFs focus on broader trends within society. Their goal is to allow investors to invest into structural shifts which will spur new industries and market sectors.

Examples for themes covered by thematic ETFs are climate change, artificial intelligence or electric mobility. These themes encompass potential changes in multiple industries and the ETFs will track companies which are expected to thrive once these trends manifest.

Bonds

A bond ETF is focusing on holding either government bonds, corporate bonds or municipal bonds. They allow investors to gain exposure to benchmark bond indices in a cost-efficient way. As bond ETFs are being traded on exchanges they also offer additional transparency as investors don’t have to pick the right bonds.

Commodities

Commodities are basic physical goods which can be manufactured by multiple producers at the same or similar quality. Common commodities are agricultural products like grains or beef, energy sources like crude oil and natural gas or precious metals like gold and silver.

A wide variety of commodity ETFs can be purchased on exchanges. Common commodity ETFs are focusing on gold, silver or palladium. These commodities are either held in safe storage facilities or being traded as futures contracts.

Commodity and market sector ETFs can have some overlaps. For example a water etf might track companies producing clean drinking water rather than actual water being stored in a storage facility.

One big advantage of commodity ETFs is that they allow investors to invest into commodities without having to know the specifics of purchasing them on specialized markets.

Currencies

Investors use currency ETFs to gain exposure to either a single or multiple currencies. A currency ETF usually is based on currency futures contracts. A futures contract is a legal agreement to buy or sell a security or commodity at a specified price and a predetermined point in the future. These ETFs tend to implement popular currency trading strategies such as focusing on currencies of commodity producing economies or currency carry trading.

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How Do ETFs Compare To Index Funds?

Both ETFs and index funds assemble their portfolio based on a fixed rule set which results in more automation and fewer human involvement. This reduces costs for investors.

However unlike ETFs index funds can only be purchased for the price set at the end of the previous trading day while the price of the ETF constantly changes throughout the day. While this will not have a long-term impact on results it can be an important aspect for day traders.

Index funds also usually have higher minimum investment requirements. While for an ETF the minimum investment price is the price of one share the minimum required investment of index funds can be higher.

ETFs also tend to be more tax efficient. When selling an investment in a index fund the fund has to sell assets and then pay out the money. This triggers costs and taxes for both the fund and the investor.

Meanwhile as the ETF is traded on a exchange the sale does not affect the fund and therefore there are only capital gains taxes for the investor. There are no taxes and costs for the ETF itself which keeps the costs of the fund low.

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How Do ETFs Compare To Mutual Funds?

Contrary to ETFs mutual funds are being actively managed. In a mutual fund a human broker is actively choosing investments for the fund while in the ETF the investments are being chosen based on a fixed set of rules. As a result ETFs generally have lower fees.

ETFs also usually show better results than mutual funds in the long run. However mutual funds might have better short-term results as the fund managers can react to current market conditions. But it is unlikely that a mutual fund will achieve consistent high performance which is better or matches the market.

Mutual funds have the same drawback as index funds in terms of tax-efficiency. When selling part of the mutual funds both costs for the fund and the investor occur. The costs for the fund have to be split between all investors which makes the mutual fund less cost-effective. At the same time the ETF is traded on an exchange and therefore only capital gains taxes for the investor apply.

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How Do ETFs Compare To Real Estate Investment Trusts?

Real estate investment trusts (REIT) are publicly traded companies which own income-producing real estate assets. Investors into REITs basically own a share of a big real estate portfolio which produces recurring dividend payments. REITs are specific to the American stock market and are required by law to distribute at least 90% of their taxable income as dividends to shareholders.

A REIT essentially acts like a ETF which is specialized in holding a wide variety of real estate assets ranking from office building, shops or apartments. This offers the same diversification to investors as ETFs would. Since REITs are required to pay regular dividends they are more similar to distributing ETFs and therefore don’t offer the tax advantages of accumulating ETFs.

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What Is The Difference Between Accumulating And Distributing ETFs?

ETFs which invest into securities that distribute dividends are offered either as accumulating or as distributing ETFs.

An accumulating ETF is reinvesting the dividends into the fund without distributing them to the shareholders of the ETF. This makes accumulating ETFs very tax efficient as no capital gains tax applies to the reinvested dividends. Distributing ETFs on the other hand distribute the dividends to their shareholders.

Investing into a distributing ETF is beneficial for income investors who live off dividends from their investments. However if the goal is to grow the investment in the long-term and reinvest dividends its wiser to invest into an accumulating ETF. This enables investors to benefit from reduced taxes and therefore higher overall growth.

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Are ETFs Open-End Funds?

Most ETFs are being created as open-end funds. A open-end fund consists of the diversified assets of all investors who own part of the fund. The fund can sell unlimited shares which are valued daily based on the net asset value of the portfolio.

Contrary to the open-end fund a closed-end fund has a fixed amount of shares which are being sold in a initial public offering (IPO). Through the IPO a fixed amount of capital is raised which represents the capital of the fund.

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What Are Leveraged ETFs?

A regular ETF is a open-end fund which can issue unlimited shares. The value of these shares is then invested into the tracked assets of the ETF. The goal is to achieve a similar overall return as the tracked index.

Comparatively a leveraged ETF attempt to generate a higher return than the tracked index by using leverage. In investing leverage is the use of borrowed capital to achieve greater returns. The trade-off of using borrowed capital is that leveraged ETFs generally tends to be riskier as the borrowed capital has to be paid back regardless of whether it generated a gain.

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What Are Hedged ETFs?

One way to protect against currency fluctuations is to buy hedged ETFs. Hedging is the practice of protecting against risks by taking a opposite position in a related asset. So if an investor in Europe invests into a ETF which is hedged with Euro he is not subject to currency fluctuation.

However even if a ETF is hedged there still is a small underlying currency risk as companies which are included in the ETF might be exposed to different currencies and might decide to not hedge against currency risks.

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What Is An Actively Managed ETF?

Most ETFs are passively managed by tracking a specific market indices, market sectors, commodities, bonds or currencies. However, an actively managed ETF consists of different securities which have been picked by portfolio managers who make active investment decisions. As such the actively managed ETF is more similar to mutual funds as the investment managers constantly oversee the fund.

While actively managed ETFs can see strong gains in the short-term they are also subject to higher management fees and increased trading costs. As a result their expense ratio is much more expensive and they rarely attractive for long-term investors.

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What Is An Inverse ETF?

By using inverse ETFs investors can not only bet on the positive but also the negative outlook of a market index, market sector, commodity, bond or currency. This is possible as inverse ETFs short assets, like stocks.

Shorting stocks is the act of betting against a price trend in the market. When investors short stocks they sell stocks at a high price to other investors who believe the share price of a stock will rise. However they hope to buy back the shares at a lower price as they expect the share price to fall. In case the share price indeed falls the investors will make a profit from the difference between the higher sell price and lower buy price. However if the price does not fall they will incur a loss.

Most inverse ETs are actually exchange-traded notes (ETNs) rather than real ETFs. As such they are not recommendable to invest into for beginner investors.

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How Is The Price Of An ETF Determined?

The price of an ETF share is based on the current market value of all assets which are being held and tracked by the ETF. Once the liabilities of the ETF have been subtracted this returns investors the net asset value (NAV) of the ETF. It is the value of the funds assets minus its liabilities. If the net asset value is divided by all outstanding shares of the ETF investors will get the net asset value per ETF share.

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How Do ETF Fees Work?

ETFs are passively managed and as a result have lower overall fees compared to mutual funds and index funds. As the ETF assets are allocated using a specific rule set, such as a market index, there is no need to actively pick investments for the fund.

Fees are deducted from the fund‘s assets and are being used to pay for the management and operational costs. The total fees of an ETF are expressed in the expense ratio. The expense ratio is the percentage of fees of the overall assets of the fund. As a result investors receive the total return of the fund minus the fees. Therefore if the total yearly of the ETF Is 10% and the ETF fee is 0.5% the return for the investor is 9.5%. The typical ETF expense ratio stands between 0.05% to 1.00%.

Generally picking a ETF with a lower costs should be preferred. However when comparing different ETFs it is important to also check that both compared ETFs track the same securities. Otherwise the expense ratios might not be comparable to each other.

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What Currency Should I Buy An ETF In?

A ETF is generally subject to different currencies:

  • The underlying asset currency is the currency in which the assets of the ETF are being traded. This currency has the highest impact on your investment results as it is subject to fluctuations between your local currency and the underlying asset currency.
  • The hedging currency is being used to protect against currency risk.
  • The trading currency is the currency in which the ETF is traded.
  • The fund base currency is the currency in which results are being reported.

For most investors the currency of the ETF is largely irrelevant as the ETF does not reflect an investment into the currency but into the underlying assets. Although the price of the ETF might fluctuate based on currency price fluctuations the underlying value of the assets is often not directly linked to the currency fluctuations.

For example if one person invests into one ETF traded in Euro and another person invests the same amount into the same ETF in British Pounds both own the same equivalent value of the underlying assets. If now the British Pound falls 50% the price of the shares in the ETF traded in British Pound would simply double since the price of the currency halved. But the underlying value is still the same.

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Are ETFs Safe?

Some investments carry more risk than others. However ETFs are generally considered to be comparatively safe investments since they invest into a well diversified portfolio of assets. As with any investment the biggest risk is the opportunity cost of losing profits investors could make with other investments.

To determine the risk of investing into ETFs investors have to figure out their:

  • the risk tolerance of an investor
  • time horizon for making their investment
  • amount they will invest
  • frequency of purchases of new ETF shares

One downside of investing into ETFs is that they will tend towards matching the performance of the tracked index, market sector, commodity, bonds or currencies. While this guarantees some safety as it will become harder to underperform the market it also makes it hard to outperform it.

Other factors to consider are the trading volume and liquidity of the ETF, the impact of fees on the expected investment returns and the use of leverage. In general leverage can yield higher returns but those will be generated at a much higher risk.

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