When it comes to investing, one of best options is called an ETF (Exchange Traded Fund). The legendary investor Warren Buffet recommends that you invest your money in ETFs for the long term. In this article, we will go over everything you need to know!
What Is An ETF? What You Need To Know
So you want to invest in the stock market, but you want your money to be safe?
Don’t worry: you’re not alone.
More risk usually means more reward; if you put your money in a volatile stock, your money could skyrocket by tomorrow.
But it could also crash.
On the other extreme, you could always stick your money in a bank account. No risk there, right?
Yes, but the interest rate for virtually any personal bank account out there fails to keep up with inflation. You lose money by leaving it in a bank account your whole life!
So is there a happy medium?
Yes, and they’re called Exchange-Traded Funds (or ETFs for short).
Time for you to learn all about ETFs: what they are, how they work, and how they differ from other types of securities (like stocks and mutual funds).
What Is An ETF?
To better understand an ETF, let’s break down the whole word. Let’s start with F (aka Fund) first.
“Fund” is part of the term because ETF’s are a collection of many diverse stocks or bonds.
As for “Exchange-Traded”, that just means it’s traded on a major stock exchange like the NASDAQ. Buying and selling ETFs is very similar to stock trading.
Put both parts together, and it’s simple: ETF’s are just “buckets filled with stocks/other securitized assets” that are traded on major stock exchanges like any other asset.
How Do ETF’s Work?
We already know that ETF’s are just collections of securities traded as one asset in the stock market.
But how are they created, and how do they work?
The Birth of An ETF
Due to both Securities and Exchange Commission (SEC) rules and massive capital requirements, only large financial management firms can create exchange traded funds.
These firms meticulously pick which assets will be part of a new ETF. When they have everything together, they send off their new ETF to the SEC for approval.
Upon a “yes” from the SEC, “authorized participants” can now buy ETF shares. This ends up being investment firms at first since they’re the only ones that can front the capital needed to make these giant purchases. After that, investment firms sell them to individual investors.
The Inner Workings of ETFs
ETFs are made up of a diverse set of assets. When you buy an ETF, you indirectly own each asset contained in the ETF.
When financial institutions buy ETF shares from the ETF, they do so in massive groups of shares called “creation units”. In exchange, the institution gives the ETF a basket of shares that match what the ETF is supposed to represent.
In essence, the ETF shares serve as a “figurehead” for the underlying assets traded to the ETF originator.
Sometimes, the market price of the ETF can deviate from the actual value of the ETF. This actual value is called the Net Asset Value, or NAV for short.
The NAV calculation is quite simple: subtract the fund’s liabilities from its assets and divide the difference by the number of shares of the fund. Your result leaves you with the value per share of the ETF.
The existence of creation units and ETFs’ abilities to purchase and redeem them allow ETFs to minimize this discrepancy between market price and NAV.
How Creation Units Reduce The Price-NAV Discrepancy
As with any other product, supply and demand will cause difference between the value of the ETF and the price at which it is traded.
But with the ability to buy and sell creation units, institutional investors can minimize the discrepancy between market price and NAV. It serves as almost an automatic regulator for the ETF.
Let’s say investor demand for ETF’s is strong: more individuals would be buying ETF shares.
Therefore, market price of the ETF would rise over the NAV. The institutions, who essentially serve as arbitrages in this scenario, would be urged to buy more shares of the ETF so they can satisfy the market demand.
With more ETF shares flooding the market, the market price shrinks. Thus, the gap between the market price and the NAV disappears.
When demand is weak, a similar process happens in the opposite direction.
In the end, it all boils down to supply and demand.
What Sets ETFs Apart?
ETFs are different from individual securitized assets simply because they are “baskets” of securitized assets.
But how are they different from their close cousin, mutual funds?
A Lightning Quick Primer On Mutual Funds
Mutual funds are investment vehicles that collect money from multiple investors and invest them into a diverse portfolio of assets.
Sounds kind of like an ETF, right?
Well, the similarities stop there.
ETFs and Mutual Funds: Not Quite The Same
ETFs and mutual funds are drastically different for a few reasons:
- Tax effects
Mutual funds and ETFs are traded differently. Because of this, the price at which each type of fund is traded differs.
The stock-trading nature of ETFs means that prices can fluctuate. You can trade ETFs all day at market price.
Mutual funds, on the other hand, are bought directly from the company that manages the mutual fund.
Oh, and they can only be bought at the end of the day.
For the investor, that means you can only purchase mutual funds at whatever their end-of-day price is, aka the NAV.
Both ETFs and mutual funds are subject to capital gains tax, but ETFs beat out mutual funds as the more tax-efficient investment vehicle of the two.
There’s no complicated legal or mathematical reasoning behind the ETF’s tax advantage; it’s more advantageous simply because less taxable events occur with ETFs than with mutual funds.
Tax liability for ETFs are only incurred when the entire ETF is sold, not just when you’re holding the ETF. You have to sell the ETF on the market to incur a capital gain.
On the other hand, when a mutual fund investor wants to trade in their mutual fund investment for cash, the mutual fund manager must sell some of the mutual fund securities in order to raise the cash owed to the investor. Thus, capital gains are incurred.
Due to multiple massive financial scandals within the last couple decades, trust in financial institutions is quite low.
Among all this, however, ETFs stand out. Compared to mutual funds, ETFs are very transparent. Here’s why:
Every type of investment (by both regulation and goodwill) makes an effort to disclose critical information that helps investors make decisions.
Mutual funds, for example, are required to reveal their portfolio holdings every quarter.
Good on them… but that’s nothing compared to ETFs.
ETF issuers aren’t required to do this, but they typically disclose ETF holdings online for free. For almost every ETF in existence, you can view it’s holdings 24/7/365.
How’s that for transparency?
A Worthy Potential Investment
From stocks, to bonds, to real estate, to mutual funds, there are investment assets to satisfy every investor.
ETFs stand out among other assets for their hybrid-like nature between stocks and mutual funds. In addition, they are tax effective, transparent assets that would look great in any portfolio.
Consider adding ETFs to your portfolio if you’re looking to diversify!