By elmads

The broader financial markets have been growing, there are always new financial funds that are being offered to the public almost every century, if not every decade. One of which is the Exchange Traded Funds, also called as ETFs. It has taken the scenes, as an another financial product that could grow our money into the short to long-term horizon. The popularity of ETFs have been increasing because of its unique ability to be traded in the stock market, unlike mutual funds which can only be bought and sold at the end of the trading day. This grants for traders to take part into buying and selling index fund types of securities.

Before I dig down deeper into Exchange Traded Funds, let’s breakdown each word first in order for us to fully understand it.

• Exchange: this is a place where investors trade their holdings with other investors. Such holdings are stocks and bonds. Both are collectively called marketable securities.

• Traded: this is the method in which investors could buy and sell marketable securities within the trading hours of the exchanges. There are a lot of exchanges in world like New York stock exchange, London stock exchange, Philippines stock exchange, Toronto stock exchange and many more. In this day and age, investors do not need to go to the specific exchanges anymore just to buy and sell securities. Investors just purchase it via online webpage and/or mobile broker application, all thanks to the help of the internet.

• Fund: It is a pool of money that is allocated for a specific purpose. In this case for investments.

With this information in place, we can now discern the basic purpose of ETFs.

It is a kind of fund that can be traded in different exchanges.

ETFs are actually the same with mutual funds in the sense that they mirror a specific index namely the S&P 500, FTSE 100, PSEI, NASDAQ and many more. Just to give you a quick recap, Index is a list of companies that are deemed representative of a certain country or sector. For instance, the S&P 500 reflects the top 500 companies in the US with the largest market capitalization, and the FTSE 100 are the top 100 companies in the UK with also the largest market capitalization. On the other hand the NASDAQ composite index comprises of the top 100 information technology companies in the US based on market capitalization as well.

NOTE: Market capitalization is computed by multiplying a specific company’s total shares outstanding to the company’s market stock price. For further information see my blog titled “How shares are made and how the stock market works” and “Stocks & Shares.”

If you want to know more about mutual funds, I have a blog discussing it titled “Mutual Funds”.

Difference of Mutual Funds and ETFs based on how both products are made.

Mutual funds are made by the institution who made the fund itself. So, if an investor wants to buy a mutual fund, they need to go to the specific institution and/or institution’s website to purchase the fund. Furthermore, when an investor wants to sell their mutual fund units they hold, they then need to go back to the institution who made the fund and sell it back to them. ETFs have a different story, the only way an investor could purchase and sell it is through market exchanges, just like stocks.

ETFs are either made by institutions who make the mutual funds or another group of people who are called sponsors. Unlike mutual funds, ETF creation does not need for them to purchase a security using cash because they can borrow the security from another fund like pension funds. Afterwards, they bundle different marketable securities into one basket. Then they will bring the basket of securities they made to an authorized participant (AP), which is usually a large financial bank and or institutional company. This is for the sole purpose of seeking an approval for the ETF to be traded in market exchanges. Subsequently, when the bank approves the ETF, that’s when it can now be bought and sold into the market.

To create an ETF a sponsor (ETF manager) will need to go to a Securities and Exchange Commission (government entity responsible to oversee investment activities) and present the plan to them. After being approve by SEC for the ETF plan, the sponsor will now look for an authorized participant, which are usually a bank and large institutional investors, who will be able to create the said ETF (APs are the legal entities who can redeem and create ETF units).

NOTE: In our times today, most Institutional investors and Banks are also both the ETF Managers (sponsor) and Authorized Participants (AP). This takes away the second step of the process. Instead They will just need the 1st step which is the approval from Securities & Exchange Commission.

The Authorized Participant (AP) will be the one creating the ETF, but unlike mutual funds, they will not need any cash to purchase various stocks, instead they will borrow different stocks from different fund companies such as pension funds and large institutional investors. Subsequently, the borrowed stocks will then be bundled all together by the AP in order to make it into an Exchange Traded Fund. These ETFs will now be traded into the stock market exchange.

To make it simpler to understand, think of it as a basket of fruits sold in supermarkets with a clear plastic protection on it. We cannot buy just the Apple inside that basket because it is bundled up and sold as a whole basket. The only way we could purchase it is by buying the whole fruits of basket.

That is exactly the same with ETFs. It is various marketable securities bundled into a basket, the whole basket is then sold into the stock exchanges. We cannot pick a single security in the ETF, we can only buy the whole basket itself.

Types of Exchange Traded Funds

ETFs are not just specifically made from stocks but also from other asset classes.

• Bond ETFs – these are ETFs based from different bonds such as government, municipal and corporate.

• Industry ETFs – based from a certain industry like technology, telecommunications, properties and more.

• Commodity ETFs – based from commodities like Gold, Silver, Crude Oil and Wheat.

• Currency ETFs – based from currencies such as GBP, USD, Yen, CAD and others.

• Inverse ETFs – These are short-selling derivative strategies. These are complex kind of ETFs. To know more about Short-Selling see my infographics on the given link provided belo

Stock Short-Seling

The advantage of ETFs compared to Mutual Funds

1.) Lower fees – they have lower fees because the company who made the ETF does not need to create and redeem the ETF anymore, unlike with mutual funds. Just like what I have said previously, this is because ETFs are traded already in the market and are not being bought or sold back to the company who made the ETF.

In addition, the Institution who made the ETF does not require any fund representative or manager anymore, which further lower the fees for ETFs.

This makes ETFs more attractive than Mutual funds.

2.) Can be traded into the market – Some investors are traders, they are the ones who buy and sell securities within the day or sometimes weeks or months. This also contributes medium to high Liquidity in the ETF markets.

3.) Lower amount of capital needed to invest – Most ETFs does not require a large sum of money to invest in it.

4.) Limits tax exposure on capital gains – This is because most ETFs are passive investments. They are like passive mutual funds but as an ETF. This means that the holdings that an ETF has does not need to be changed regularly, not unless the market index it follow have changes in the company they hold. Less buy and selling within the fund, the less trading fees it will incur.

The disadvantage of ETFs compared to Mutual Funds

1.) Difficult to outperform the index it follows – This due to the fact that most ETFs do not have any active fund managers to outperform the market unlike active mutual funds.

2.) Low trading volume depending on the ETF – Some ETFs have low trading volume which result into a higher bid-ask-spread of its prices. This means that some ETFs can be very illiquid, or in layman’s term there is a few number of people buying or selling it.

These are the basic Pros and Cons of ETFs compared to Mutual funds. Nonetheless, both of them are generally the same.

To sum it up

Just like other investment products in our world, ETFs have its own advantages and disadvantages too. Knowing this will give us more investment option to take into consideration. Having both ETFs and Mutual Funds can be a viable option if this can aid you to achieve your financial goals. Knowledge in investing and the various investment vehicles will make the big difference into steering away from the pit falls, or if everything goes well, the potential upside of our investment returns

I end my blog with an insightful quote from the founder of Vanguard group and the father of index funds, John C. Bogle.

“During the past decade, the principles of the traditional index fund have been challenged by a sort of wolf in the sheep’s clothing, the exchange-traded fund. But let me be clear There is nothing wrong with investing in those indexed ETFs that track the broad stock market, just so long as you don’t trade them.”

john c. Bogle

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.