Japan’s Peak Global Management press: What Are Exchange -Traded Funds and How Do They Work?

Exchange-traded funds or ETFs have become increasingly popular over the past two decades. Cheaper than mutual funds and more efficient in terms of taxes, ETFs are some of the most common investment options among beginner and experienced investors alike. These funds are traded the same way as bonds or stocks. What sets ETFs apart is that they track the performance of different indexes or assets. For example, exchange-traded funds can track benchmarks like S&P 500. ETFs are considered among the safest and most affordable investment types and they are ideal for passive investors.  Learn more about what ETFs are, how they work, and how they can benefit you.

What Are ETFs?

Investopedia defines ETFs as a basket of securities that can be traded on exchanges just like regular stocks. These are pooled investment securities that work like mutual funds. Exchange-traded funds track different index types, assets, sectors, or commodities. ETFs are basically funds that include a variety of underlying assets, such as stocks, bonds, and commodities.

According to Finance Strategies, the most popular types of ETFs are those that track commodities, equities, real estate, fixed income, currency, or niche investments. The same source mentions Vanguard, BlackRock, and State Street as the most dominant names on the ETF scene. Other major players in this sector are Fidelity Investments and Charles Schwab.

How Did ETFs Develop?

The Standard and Poor’s Depositary Receipts (SPDR) was the first ETF on the US market. It was launched by State Street Global Advisors in 1993. Since then, other ETFs came into existence, including international ETFs that deal with foreign-based securities. The SPDR remains the largest ETF worldwide and it tracks the S&P 500, having around $255 billion in managed assets. In 2017, this ETF changed its name to PDR S&P 500 ETF. In 2002, the first bond ETF was launched. Nowadays there are thousands of different ETFs that track any type of asset in the investment spectrum. These popular investment options have been growing constantly since the 2008 – 2009 recession. By that time, many investors were disappointed by the poor performance of actively managed funds and decided to turn to this cheaper investment strategy. It is estimated that by 2030, the ETF market will reach $50 trillion in assets.

What Are the Advantages of Investing in ETFs?

The reason why ETFs are appealing to many investors, especially newcomers who are not ready to invest large amounts of money is their affordability. Compared to mutual funds, ETFs have a lower expense ratio. Also, investors who want to buy ETF shares don’t need a minimum investment amount.

ETFs are also more profitable because of their low fees. Unlike actively managed funds, ETFs are passively managed, which eliminates costs such as management fees, load fees, or service fees.

Compared to other assets whose returns immediately become subject to taxes, ETFs are more tax-efficient. If you generate returns by redeeming your shares from a mutual fund, the tax you have to pay is correlated with the return amount. ETFs trigger lower tax exposure because trading them is carried out through an exchange and shares are not redeemed every time investors want to sell them.

ETFs are also ideal for investors who want to diversify their portfolios and expose themselves to lower risks. ETFs track a wide range of stocks and market segments from specific assets to a group of securities or an investment strategy. Whether you want to invest in bonds, company stocks, or commodities, you can find ETFs that offer these options and more. Because of their diversity, these investments allow more flexibility. You can choose the strategy or asset that appeals to you the most. For instance, some ETFs only offer assets from the US market, whereas others offer access to foreign assets. You can also choose ETFs that combine assets across different industries or, on the contrary, focus on a single business sector.

ETFs are also flexible because of how they are regulated. On the US market, the majority of ETFs are created as open-ended funds, which means they are regulated by the Investment Company Act of 1940 and are not limited to a specific number of investors per product.

ETF prices are dynamic and constantly updated. For open-ended mutual funds, the price is established at the net value at the end of the day, when the market closes. That is the only moment when they can be traded as mutual funds are not available for trading on exchanges. ETFs, on the other hand, can be traded throughout the day, just like stocks.

Their wide availability also makes ETFs suitable for investors who are looking for diversification and are used to trading stocks. ETFs work similarly and are easy to buy and sell. Everyday investors find ETFs easy to manage as they can be traded throughout the day and are compatible with different strategies, including margin trading and shorting.

Article curtesy of Peak Global Management Japan.