Why Invest In ETFs

Why Invest In ETFs

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Introduction

Why invest in ETFs? Here are 9 reasons.

Exchange-traded funds (ETFs) have several characteristics that may make them the best investment vehicles for young investors with limited resources.

One benefit of using exchange-traded funds is that even with modest initial investments, you can create a diversified portfolio.

ETFs also have a lot of liquidity because they trade all day long, and many of them have relatively inexpensive structures.

What Are ETFs?

A collection of investments, such as bonds or stocks, is known as an exchange traded fund, or ETF. Exchange-traded funds (ETFs) let you invest in a variety of securities at once, and they frequently charge lower fees than other types of funds. The trading of ETFs is also simpler.

ETFs, however, are not a universally applicable financial product, just like any other. Examine them based on their own merits, taking into account the management fees and commissions (if any), the ease of purchase and sale, the way they would fit into your current portfolio, and the investment quality.

How Do ETFs Work?

During the day, when stock exchanges are open, an ETF is purchased and sold similarly to a stock in a company. An ETF, like a stock, has a ticker symbol, and during the course of the trading day, intraday price data is easily accessible.

Because new shares are perpetually issued and existing shares are perpetually redeemed, an ETF’s share count can fluctuate daily unlike a company stock. The market price of ETFs is kept consistent with the value of their underlying securities by an ETF’s ability to continuously issue and redeem shares.

The creation units, which are sizable blocks of ETF shares that can be exchanged for baskets of the underlying securities, are a crucial component of institutional investors’ role in preserving the ETF’s liquidity and tracking integrity, despite the fact that the ETF is intended for individual investors.

Institutions use the arbitrage mechanism provided by creation units to bring the price of the ETF back into alignment with the value of the underlying asset when it diverges from that value.

Why Invest In ETFs?

1. Trade ETF With Flexibility

Why invest in ETFs? Trading ETF comes with a lot of flexibility. Shares of conventional open-end mutual funds are traded just once each day, immediately following the close of the markets.

The mutual fund issuer is where all trading takes place. Investors cannot determine the price they paid for new shares when purchasing them on a given day or the price they will receive when selling them until the fund’s net asset value (NAV) is announced at the end of the business day.

The majority of long-term investors can be satisfied with once-per-day trading, but some people need more flexibility.

When the markets are open, ETFs are purchased and sold. ETF shares are continuously priced throughout regular trading hours.

Share prices fluctuate throughout the day, primarily due to changes in the intraday value of the fund’s underlying assets. Investors in ETFs are instantly aware of the price they paid for shares and the price they received when they sold them.

The trading of ETF shares happens almost instantly, which makes managing a portfolio intraday a breeze.

Moving money between particular asset classes, like stocks, bonds, or commodities, is simple. In an hour, investors can efficiently allocate their funds to the investments they want, then change their allocation the following hour. Although it is not typically advised, it is possible.

It can take several days and is more difficult to make changes to traditional open-end mutual funds. To begin with, open-end share trades are typically only accepted until 2:00 p.m. Eastern standard time.

By extension, you are in the dark regarding the NAV price’s final value. It is impossible to predict the exact price at which shares of one open-end fund will trade or the amount at which you should purchase shares of another open-end fund.

ETFs’ trade order flexibility enables investors to make timely investment choices and place orders in a number of different ways.

Limit orders and stop-limit orders, along with other trading options, are all available when purchasing ETF shares. ETFs may also be bought on margin using a broker’s credit. There are tutorials on different trade order types and the criteria for margin borrowing at every brokerage firm.

Investors in ETFs have access to short selling as well. Shorting entails obtaining securities on loan from your brokerage company and selling them at the same time. The idea is to borrow securities in the future, with the intention of buying them back at a lower cost.

2. There Is A Variety Of ETFs

Why invest in ETFs? There’s a variety of ETFs that you can choose from.

The first exchange-traded funds (ETFs) were relatively simple, vanilla products that tracked equity indices like Dow Jones Industrial Average and the Standard & Poor’s 500 Index when they were first introduced in the late 1980s and early 1990s.

Since then, virtually every asset class—including stocks, bonds, currencies, real estate, commodities, and international investments—as well as every sector imaginable and a large number of specialized markets are now covered by the wide variety of ETFs that are readily available.

ETFs with a narrow focus have been introduced as a result of competition among ETF issuers. Young investors can use this information to locate specific ETFs that track industries, markets, or other market segments that may be of particular interest to them.

Inverse ETFs are also available, and they trade in the opposite direction from an asset or market. Additionally, there are leveraged ETFs that multiply results by two or three.

According to information from Fidelity Investments, as of the beginning of 2020, there were at least 2,177 exchange-traded funds with U.S. origins.

These numerous ETF options provide a wide range of investment options for new investors.

The variety of ETFs also makes it possible for investors to create diversified portfolios with less capital investment than would have been necessary in the past. Think about a young investor who has $2,500 to invest.

Assume that this investor is an avid student of the financial markets and has clear opinions about particular investments.

They have high expectations for the U.S. equity market and want exposure to U.S. stocks to be their primary investment strategy, but they also want to take smaller positions to express their bullish sentiments toward gold and the Japanese yen, which they anticipate will both rise.

Using ETFs, an investor with $2,500 can create a portfolio that includes all points of view, whereas in the past it would have required a much larger investment, particularly before the development of commodity and currency ETFs.

This investor might, for instance, put $1,500 into the Standard & Poor’s Depositary Receipts 500 Trust (SPY) and $500 each into the Invesco CurrencyShares Japanese Yen Trust (FXY) and the SPDR Gold Fund (GLD).

3. ETF Offers Risk Management And Portfolio Diversification

Investors who lack expertise in those fields may want to quickly diversify their portfolio by adding exposure to certain sectors, styles, industries, or nations.

ETF shares might be able to give a buyer simple access to a particular target market segment given the wide range of style, sector, industry, and country categories that are available.

Nowadays, almost all of the world’s major asset classes, commodities, and currencies trade ETFs. Additionally, cutting-edge new ETF structures represent a specific trading or investment approach. For instance, an investor can purchase or sell stock market volatility through ETFs, or they can make ongoing investments in the currencies with the highest yields.

In certain circumstances, an investor may have a sizable amount of risk in a particular industry but be unable to diversify that risk due to regulations or taxes. In such a scenario, the investor can short an industry-sector ETF or purchase an ETF that does so for them.

In the semiconductor sector, for instance, a shareholder might possess a sizable number of restricted shares. In that case, the individual might want to sell short shares of the SPDR Semiconductor (XSD) of Standard & Poor (S&P).

In doing so, one would be exposed to that sector’s downturn for a lower overall risk. The XSD index tracks semiconductor stocks listed on the NASDAQ National Market, American Stock Exchange, New York Stock Exchange, and NASDAQ Small Cap exchanges. It is equally weighted by market capitalization.

4. Most ETFs Are Very Liquid

Why invest in ETFs? Most ETFs are very liquid that you can trade them all day. Since ETFs are traded on exchanges, you can buy and sell them at any time of the day. In other words, investors can quickly and fairly sell an ETF to realize their gains.

In contrast, investing in something like a house can be viewed as being less liquid because it would take longer to find a buyer and you might have to accept a sizable discount if you ever needed to sell it quickly. ETFs are a helpful tool for an investor who wants to quickly enter or exit a market because of this feature.

In contrast to index mutual funds, which are only priced at the end of the business day, the majority of ETFs are very liquid and can be traded all day.

For the young investor, who might want to get out of a losing investment right away to preserve their limited capital, this turns into an especially important differentiating factor. Additionally, since there is a lot of liquidity, investors can trade ETF shares intraday just like stocks.

5. ETF Has Lower Costs

Why invest in ETFs? Trading ETFs demand lower fees. In general, expense ratios for exchange-traded funds are lower than those for mutual funds.

A lot of online brokers also provide commission-free ETFs to investors with small accounts, despite the fact that they are traded similarly to stocks.

Young investors may find this to be very beneficial as high fees and commissions may significantly reduce their account balance.

Regardless of the structure, all managed funds have operating costs. These expenses consist of distribution fees, administrative fees, marketing expenses, custody fees, and fees for portfolio management.

Costs have historically played a significant role in predicting returns. Generally speaking, the expected return for a fund is higher the lower the cost of investing is.

In contrast to open-end mutual funds, the costs associated with operating ETFs can be reduced. The brokerage companies that hold the exchange-traded securities in customer accounts incur client service-related costs, which results in lower costs.

When a company does not need to staff a call center to handle inquiries from thousands of individual investors, fund administrative costs for ETFs can decrease.

In terms of monthly notifications, statements, and transfers, ETFs also have lower costs. Regular shareholder statements and reports must be sent by traditional open-end fund companies.

Not so with ETFs. Only authorized participants who are the legal owners of creation units shall be given access to that information, according to the fund sponsors. Through brokerage firms, individual investors can buy and sell single shares of comparable stocks, and it is the brokerage firm—rather than the ETF companies—that is in charge of looking after those investors.

Quarterly reports, 1099s, annual tax reports, and monthly statements are all produced by brokerage firms.

As a result of the decreased administrative costs associated with serving and maintaining records for thousands of individual clients, ETF companies have lower overhead, and at least some of those savings are distributed to individual investors in the form of lower fund expenses.

Lack of mutual fund redemption fees is another cost-saving benefit of ETF shares. In contrast to some open-end funds, ETF shareholders are exempt from short-term redemption fees. An illustration would be the Investor Shares in the Vanguard REIT Index Fund (

If held for less than a year, there is a 1% redemption fee for VGSIX). There are no redemption costs for the Vanguard REIT ETF (VNQ), which has the exact same portfolio.

6. You Can Keep Up With Trends Through ETFs

ETFs’ issuers have been on the cutting edge when it comes to introducing new and cutting-edge products, which is one of the main factors for their explosive growth. In general, ETF issuers have quickly met consumer demand for goods in burgeoning industries.

When commodities were in high demand from 2003 to 2007, for instance, many commodity ETFs were introduced. These ETFs tracked a variety of commodities; others focused on particular commodities, like gold and crude oil, while some tracked broad commodity baskets. 

There are also a number of ETFs that have been introduced that follow ESG investing principles.

7. ETF Is Very Transparent

Why invest in ETFs? ETF is very transparent. Daily holdings disclosures are made by ETFs so you always know what you’re buying.

Unlike traditional funds, which typically only disclose their top 10 holdings, and even then, frequently on a delayed basis, ETFs typically allow you to look inside and see exactly what you are buying.

8. ETF Has A Lot Of Tax Benefits

Why invest in ETFs? You can take advantage of tax benefits that come with trading ETF.

When compared to mutual funds, ETFs have two significant tax advantages. Capital gains taxes on mutual funds are typically higher than on ETFs because of structural differences.

In addition, investors only pay capital gains tax on ETFs when they sell them, whereas mutual funds charge investors capital gains tax throughout the duration of the investment. In summary, ETFs have lower capital gains and only have to pay them upon selling the ETF.

For ETFs, the dividend tax situation is less favorable. Qualified and unqualified dividends are the 2 types of dividends that ETFs issue.

A minimum of 60 days must have passed before the dividend payout date for an investor to hold the ETF in order for the dividend to qualify.

Depending on how much income tax an investor pays, the tax rate on qualified dividends ranges from 5% to 15%. The investor’s income tax rate is applied to unqualified dividends.

The structure of exchange-traded notes, which are regarded as a subset of exchange-traded funds, is designed to avoid dividend taxation. ETNs do not actually issue dividends, but their value is reflected in the price of the ETN.

9. ETFs Provide Investment Management Options

Investors can manage their investments using ETFs in a passive, active, or hybrid style of their choosing.

Active management involves a more hands-on approach and the selection of particular stocks or sectors in an effort to “beat the market,” whereas passive management or index investing, merely entails building a portfolio to mimic one or more market indexes.

Young investors who aren’t completely familiar with the complexities of the financial markets would be best served by starting with a passive management strategy and gradually transitioning to a more active style as their investing knowledge improves.

Sector ETFs allow investors to adopt bullish or bearish positions in particular markets or sectors, while inverse ETFs and leveraged ETFs allow for the incorporation of sophisticated portfolio management techniques.

Common Types Of ETFs

The majority of exchange-traded funds (ETFs) are benchmark- or index-based and seek to replicate one or more of these.

These indexes may be based on bonds or stocks, such as the Hang Seng. An index ETF holds all or a representative sample of the index, depending on the underlying asset, and tracks index performance as a result.

The top 50 companies by size that are listed on the Hong Kong Stock Exchange are tracked by the Hang Seng Index in Hong Kong, for instance. Every one of the 50 stocks in an ETF that tracks the Hang Seng will typically be held in the same proportion as the Index.

1. Equity ETFs

Equity ETFs follow an index of stocks. You can select ETFs that invest in stocks from a particular nation, big businesses, small businesses, or both. Equity ETFs are a popular option because they allow you to target industries that may be performing well at the time, such as technology or banking stocks.

2. Bond and Fixed-income ETFs

Your portfolio should be diversified. It’s just good practice to spread your investment risk. Because they offer a consistent return at a potential lower risk than equity ETFs, the majority of professionals also invest in fixed-income and bond ETFs.

3. Commodity ETFs

ETFs are a fantastic way to invest in commodities like gold, silver, or oil even though they are frequently more difficult to access than stocks. To further diversify your portfolio and risk, these are desirable substitutes for stocks.

Commodity ETFs, however, may offer less transparency than index or stock ETFs. The underlying asset, such as gold, is frequently not directly owned by them; instead, they use derivatives.

While derivatives follow the underlying price of the commodity, they can be riskier than ETFs that directly own the underlying asset due to counterparty risk, for example.

4. Currency ETFs

Currency ETFs can invest in a basket of currencies or a single currency, such as the US dollar. The ETF may invest in the currency directly, indirectly through derivatives, or both. Derivatives may increase the risk associated with the ETF, so you must be certain of what you’re purchasing.

If you believed the underlying currency was likely to strengthen or if you desired to secure or hed your investment portfolio, you would purchase a currency ETF. Some exchange-traded funds (ETFs) that invest in international markets may already “hedge” against currency risk.

5. Speciality ETFs

Leveraged funds and inverse funds are two newer fund types that have emerged to address very specific needs. The growth potential of these specialty ETFs is much higher, but the risk is also much higher.

• Similar to when investors short sell a stock as its price declines, inverse funds increase in value when the target index declines.
• By using more debt (leverage) to make investments, leveraged funds seek to maximize returns. These ETFs can be identified by the amount of leverage they typically disclose, for instance, 2X will borrow an additional $1 for every $1 investors invest in the fund.

Both of these ETF types have the potential to provide high returns but also carry a high risk, so do your research and know what you’re buying.

6. Factor ETFs

Targeting particular drivers of return across asset classes is part of the investing strategy known as factor investing.

Factors have been used to manage portfolios for decades by institutional investors and active managers. Rules-based ETFs are a popular way to gain access to factors. known as “Smart Beta” a lot.

7. Sustainable ETFs

The variety of available sustainable ETFs is expanding quickly. Traditional investment strategies are combined with knowledge about the environment, society, and governance in sustainable investing.

The number of investors who are investing in sustainability is rising. Trends in demographic change, governmental regulations, and shifting perspectives on risk are driving demand.

Other Types Of ETFs

• Sector and Industry ETFs: Designed to introduce people to a specific industry, like oil, medicine, or high technology
• Index ETFs: Created to follow a specific index, such as the NASDAQ or the S&P 500
• Inverse ETFs: intended to make money if the underlying market or index drops
• Style ETFs: Designed to track a particular investment strategy or market capitalization focus, such as large-cap value or small-cap growth
• Exchange-traded notes (ETNs): In essence, access to illiquid markets was made possible by the creation of debt securities backed by the issuing bank’s creditworthiness; they also have the added advantage of producing essentially no short-term capital gains taxes.
• Leveraged ETFs: conceived to maximize returns by leveraging leverage
• Foreign market ETFs: Designed to track foreign markets, such as Hong Kong’s Hang Seng index or Japan’s Nikkei Index
• Alternative Investment ETFs: Creatively designed products that give investors access to specific investment strategies like covered call writing or currency carry, or allow them to trade volatility.
• Actively Managed ETFs: Contrary to the majority of ETFs, which are created to track an index, this one is created to outperform it.

Final Thoughts

A wide range of investors use ETFs to create portfolios or increase their exposure to certain industries. 

In terms of how they trade, they can be compared to stocks, but their price movements can also be compared to those of broader investments or even entire indices. When compared to other managed funds, like mutual funds, they have a lot of benefits.

However, there are drawbacks to be aware of before placing an order to buy an ETF. The options may be more constrained in terms of diversification and dividends.

Without a nimble manager to protect performance from a decline, instruments like ETFs that are based on an index can both live and die by that index. Finally, when deciding if ETFs are right for you, you should take into account the tax implications involved (as with any investment).

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Adam is an internationally recognised author on financial matters, with over 760.2 million answer views on Quora.com, a widely sold book on Amazon, and a contributor on Forbes.