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What is an ETF?


An ETF is an exchange traded fund that tracks indexes like the NASDAQ and the S&P 500. One of the most popular ETFs is called the Spider and trades under the ticker SPY. When you invest in an ETF, you are investing in a portfolio that tracks that specific index’s yield and return. Although ETFs have existed since the early 1980s, they’ve become more popular in the last 10 years.

Currently, there are approximately 2,000 ETFs on the market, with a market capitalization of more than $2.3 billion. Some people confuse ETFs with mutual funds and index funds. To draw the distinction, let’s discuss them all.

ETFs VS Mutual Funds

What is the difference between ETFs and mutual funds? Mutual funds have a professional adviser who actively manages the portfolio on behalf of all the investors for a fee. Their goal is to outperform the overall market return. On the other hand, ETFs simply tries to replicate an index fund’s performance rather than outperform it. When you invest in a mutual fund, it is similar to investing in a fund manager since the manager is actively trying to outperform the market. When you invest in an ETF, you are investing in the market itself.

Unlike mutual funds, you can trade an ETF like a common stock. Since they are traded on public stock exchanges, they can be bought and sold at any point during the day. Mutual funds are only priced and traded after market close. Since it trades like a stock, an ETF does not have its net asset value (NAV) calculated everyday like a mutual fund does. ETFs usually have higher daily liquidity and lower fees than mutual funds. With ETFs, you pay the same commission to your broker as you would pay for any other order.

ETFs VS Index Funds

Index funds track a specific index, such as S&P 500 and Dow Jones Industrial Average. There are indexes on all different market sectors such as financial, healthcare, and tech. Index funds typically have low active management fees. Unlike a mutual fund, where a manager chooses stocks to buy, an index fund buys all the shares that make up a specific index, like the S&P 500. The goal is to replicate the performance of that entire market.

Since index funds buy and hold instead of trading frequently, they are cheaper to invest in. When you invest in an index fund, you gain the average return of all the stocks in that market.

Why buy ETFs?

The goal of an ETF is to replicate a particular market index. By investing in ETFs, you can diversify your portfolio with the simplicity of making one trade. A key feature of ETFs is its passive management, where the fund manager only makes periodic trades.

Another benefit of ETFs is that it is tax efficient. When we sell a stock at a gain, we have to pay tax on the realized capital gain. Since ETFs have fewer capital gains than actively managed funds, they’re more tax efficient. Shareholders also do not have to pay tax from sales inside the fund, as they commonly do with mutual funds. With mutual funds, shareholders have to pay tax on sale of securities within the fund even if they have an unrealized loss on the overall mutual fund.

Investing in an ETF is less expensive than most mutual funds. The administrative costs are lower because they’re not actively managed. These lower costs and lower capital gains taxes mean a greater overall return on investment for you.

ETFs also offer better transparency than mutual funds, which are only required to disclose their portfolios on a quarterly basis. ETFs disclose their full portfolios and you can find all their holdings online. Since ETFs represent baskets of stocks, they generally trade at much higher volumes than individual stocks. This means high liquidity, allowing investors to get in and out of investment positions with less risk and expense.

Some mutual funds charge a penalty if you sell early, such as 90 days after you bought it. With ETFs, there is no minimum holding period and no penalties.

Investing in ETFs is a great option for passive investors. If you don’t have the time or resources, buying an ETF is a great way to add diversification to your portfolio.

Best ETFs 2017

Warren Buffet as mentioned several times that most people are better off investing in a simple, low-cost S&P 500 ETF. One of the best ETFs is the Vanguard S&P 500 index fund. This index fund is available in both ETF and mutual fund forms. The Vanguard S&P 500 ETF (VOO) tracks the S&P 500 index, which is comprised of 500 of the largest publicly traded U.S. companies. Over a long period of time, the S&P 500 has outperformed many of the actively managed large-cap mutual funds, averaging annual returns of 9-10%. This is a great option for new investors, as it allows you to have a diversified portfolio of the largest American companies with a low management fee.

Another popular Vanguard ETF is the Vanguard Total Stock Market ETF (VTI), which tracks the performance of the CRSP US Total Market Index. The fund is one of the most diversified because it represents every investable stock trading on the U.S. exchanges. This is a great way to have a mixture of large-, mid-, and small-cap stocks.

If you want a little more reward, you can invest in the iShares Core S&P U.S. Growth ETF, which invests in companies with above-average growth potential. Of course, with more rewards comes greater risk, as these stocks tend to be a little more volatile. This fund tracks the S&P 900 Growth Index, which is comprised of large- and mid-cap American companies that have growth characteristics. These are companies with earnings that are expected to grow above the rate of the average company in the same industry. The fund’s top five holdings are Alphabet (Google), Amazon, Apple, Facebook, and Microsoft. Over the short-term, these stocks can be a little volatile but they have a higher growth potential over the long-term. This ETF is attractive to new and young investors.

There are also ETFs that are dividend-focused. Some of the 2017 top dividend ETFs include Schwab U.S. Dividend Equity ETF (SCHD), Vanguard Dividend Appreciation ETF (VIG), Vanguard High Dividend Yield ETF (VYM), iShares Core High Dividend ETF (HDV), and iShares Core Dividend Growth ETF (DGRO).

Leveraged ETFs

Leveraged ETFs are higher risk investments that use financial derivatives and debt instruments to magnify the returns. A regular ETF tries to replicate the benchmark index’s performance 1:1 but a leveraged ETF will aim to match it 2:1 or 3:1. This means if the index the ETF is tracking goes up 3 percent, a 2x bullish ETF would go up 6 percent and a 2x bearish ETF would go down 6 percent. Bearish ETFs that try to magnify the exposure to an index are called inverse ETFs. However, sometimes leveraged ETFs do not maintain their 2x or 3x performance relative to the benchmark index, which is why these investments are higher risk. Although higher returns sound appealing, leveraged ETFs are intended for professional traders and should be traded with caution.

How do you buy ETFs?

ETFs are listed on an exchange and you need to have a brokerage account in order to trade those shares. Once you have a brokerage account, you can trade them easily online or even on your phone. They trade like stocks, where you pay a brokerage commission whenever you buy and sell. You can purchase ETF shares on margin, short sell, or hold for the long-term.

ETFs or Mutual Funds?

Some investors have noticed in the past that major indexes were outperforming actively managed funds. Thus, they believe that, overall, index funds make better investments than mutual funds and a buy-and-hold strategy is the best. This investment theory is also known as the Efficient Market Hypothesis, which states that it is impossible to beat the market. According to this theory, the stock market is efficient and current share prices already incorporate all relevant information and are trading at their fair value. This makes it difficult to buy undervalued stocks and sell for a high return. If you believe in this theory that it is impossible to outperform the market by stock selection or timing the market, then it would make sense for you to invest in ETFs.

However, if you don’t want to settle for just the “average” return of all the stocks, you can pick and choose the stocks to invest in and outperform the market. This is the goal of technical analysts and swing trading. They try to time and beat the market by studying charts. They argue that prices tend to follow a predictable pattern. This is why we study technical indicators and stock chart patterns.

Check out the ETF screener to find ETF trade ideas.

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