ETF Overview for Beginners

ETFs, Exchange Traded Funds, can be used in a number different ways to safeguard your investment portfolio or to increase your wealth. ETFs are a relatively new financial instrument. They have a number of advantages over traditional mutual funds. But you still need to know what you are doing if you are going to invest in ETFs. Here is an ETF overview for beginners, explaining the basics.

ETF stands for Exchange Traded Fund and is simple a collection of securities that you can buy and sell over a stock exchange. As an ETF investor you are simply buying an interest in a pool of securities and other assets. In essence, an ETF is similar to a mutual fund but it is traded like individual stocks, through a brokerage firm on a stock exchange. While the price of a mutual fund is the same the whole day, the price of an ETF changes all time, exactly as share prices.

Already in 1989, shares that tracked the S&P Index were sold. But it became a short-lived experiment after a lawsuit stopped the sale of the shares in the US. The first Exchange Traded Funds was launched in 1993. The first few years not much happened but after a couple of years, ETFs in all possible shapes and forms started to appear. The main types of ETFs are tracking either stocks, bonds, commodities or currencies. Leveraged ETF are more volatile than standard ETFs which will increase your profits and losses. ETFs are typically passively managed but lately actively managed ETFs have been launched.

Note that the market value of an ETF is not the same as the net asset value, NAV. NAV is the underlying value which is the total value of the assets and the cash in the fund. The price of an ETF on the other hand is decided by supply and demand. This can be confusing since the performance of an ETF is typically based on the NAV. That said, the difference between the market price and the NAV is generally very small.

The main advantage of ETFs is that you can build a diversified portfolio yourself, even if you have limited assets. ETFs cover virtually all industries and countries. But ETFs are not limited to just shares, they cover all major assets classes including bonds, commodities and currencies. Lower cost is often mentioned as another big advantage. But in practice the savings can be very small compared with cheap mutual funds. ETFs don’t have any client related service expenses. If you questions about an ETF, you talk to your stock broker not to the company which is responsible for the ETF. Unlike mutual funds, ETFs don’t issue any quarterly reports. On the other hand, like mutual funds, ETFs also have operating expenses. ETFs have some tax advantages, generally you will pay less capital gains tax and it is only payable when you sell the ETF.

Note that ETFs allow you to place special orders such as limit orders, stop-loss order and buy on margin. You can also trade in ETF options and short selling.

ETFs give you a lot of flexibility but you need to beware of potential drawbacks as well. First, far from all ETFs are low cost funds. Over time, the expense ratio has increased. Some ETFs are charging more than one percent in fees. That is significantly more than cheap index funds. Trading costs can be high, especially if you trade often or use an expensive broker. The spread, the difference between the buy and sell price, can also be large for some ETFs. Another thing to be aware of is the tracking error. ETFs are supposed to track an index. Unfortunately it is impossible to track an index perfectly. In many cases, the tracking error is very small but there are plenty of exceptions.

Thanks to the huge number of ETFs and the flexibility of ETFs, they can be used in many ways. ETF investment strategies include everything from just investing in the S&P Index to creating your own hedge fund. Here you can read more about popular ETF strategies.

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