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The Basics of ETFs: A Beginner's Guide

The Basics of ETFs: A Beginner's Guide
Updated:
June 11, 2023
By
Liam Langers

Exchange-traded funds (ETFs) have become increasingly popular among investors in recent years, and for a good reason.

They offer a range of benefits, including liquidity, diversification, and cost-efficiency.

But what exactly are ETFs, and how do they work?

This beginner's guide will provide a comprehensive introduction to ETFs, covering everything you need to know to start investing in these versatile financial products.

What are ETFs?

An ETF is an investment fund that holds a basket of securities, such as stocks, bonds, commodities, or currencies. ETFs are traded on stock exchanges like individual stocks, which means their prices fluctuate throughout the trading day based on supply and demand.

However, unlike traditional mutual funds, ETFs can be bought and sold at any time during the trading day, allowing for greater flexibility in managing your investments.

One of the main benefits of ETFs is the ability to gain exposure to a wide range of assets and market segments.

For example, an ETF that tracks the S&P 500 index provides exposure to the largest 500 companies in the United States, while an ETF that tracks a specific sector, such as technology or healthcare, provides exposure to a specific market segment.

ETFs can also provide exposure to international markets, bonds, commodities, and currencies, which can be challenging to invest in directly.

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Read this review about BlackBull Markets (Broker)

How do ETFs work?

ETFs are created and managed by investment companies, who determine the composition of the underlying basket of securities.

The fund's value is determined by its underlying assets, which are bought and sold by the fund manager to maintain the desired composition.

ETFs must also disclose their holdings and net asset value (NAV) daily, providing transparency and accountability to investors.

Creation and Redemption

Creating and redeeming ETF shares is known as "in-kind" transactions.

Authorized participants, usually large financial institutions, can create new ETF shares by delivering a basket of the underlying assets to the ETF issuer in exchange for new ETF shares.

Conversely, authorized participants can redeem ETF shares by delivering ETF shares to the ETF issuer in exchange for the underlying assets.

These transactions happen off-exchange and help keep the ETF's market price in line with its net asset value.

The Different Types of ETFs

There are several different types of ETFs, each with its characteristics.

Some of the most common types include:

Equity ETFs

Equity ETFs hold a basket of stocks, providing exposure to a specific market, sector, or index.

For example, an ETF that tracks the S&P 500 index provides exposure to the largest 500 companies in the United States, while an ETF that tracks a specific sector, such as technology or healthcare, provides exposure to a specific market segment.

ETFs can also provide exposure to international markets by tracking indexes such as the MSCI EAFE, which tracks companies in developed markets outside of the US and Canada.

Bond ETFs

Bond ETFs hold a basket of bonds, providing exposure to the fixed-income market.

These ETFs can provide exposure to various bonds, such as government, corporate, and high-yield bonds.

Bond ETFs can also be used to gain exposure to specific segments of the bond market, such as short-term or investment-grade bonds.

Commodity ETFs

Commodity ETFs hold physical commodities, such as gold or oil, providing exposure to the commodity markets.

These ETFs can be used to gain exposure to specific commodities or a basket of commodities.

Currency ETFs

Currency ETFs hold foreign currencies, providing exposure to the foreign exchange market.

In addition, these ETFs can provide exposure to specific currencies or a basket of currencies.

It's essential to be aware that ETFs that hold physical assets such as commodities and currencies are subject to storage and insurance costs which can affect the return of the ETF.

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Read this review about XM.com (Trading Platform)

Key Concepts of ETFs

Liquidity

ETFs are traded on stock exchanges, meaning they can be bought and sold at any time during the trading day.

This provides greater liquidity than traditional mutual funds, which can only be bought or sold at the end of the trading day.

This liquidity allows ETF investors to enter or exit their positions quickly and at any time in response to market conditions or personal circumstances.

Diversification

ETFs provide diversification by holding a basket of securities, which can help to spread risk and reduce volatility in a portfolio.

For example, by investing in an ETF that tracks the S&P 500, an investor gains exposure to 500 different companies across various sectors rather than just investing in a single company.

Diversification can also be achieved by investing in ETFs that track different market segments, such as international markets, bonds, commodities, and currencies.

Cost-efficiency

ETFs generally have lower expense ratios than traditional mutual funds because ETFs have a passive management strategy.

This means the ETFs are designed to track a benchmark index and don't require a fund manager to research and make buy and sell decisions.

Additionally, ETFs' in-kind creation and redemption process allow them to avoid the capital gains taxes associated with traditional mutual funds.

Transparency

ETFs must disclose their holdings and net asset value (NAV) daily, providing transparency and accountability to investors.

This allows investors to see exactly what the ETF holds and the value of those holdings, which can help make investment decisions.

Flexibility

ETFs can be used in various ways, such as for long-term growth, income generation, or to gain exposure to specific markets or sectors.

Additionally, ETFs can be used with different investment strategies such as passive investing, smart beta, and risk management concepts like diversification, stop-loss orders, and position sizing.

ETF Strategies

Passive Investing

Passive investing is a strategy in which an investor aims to replicate the performance of a specific market, sector, or index.

This is often achieved through investing in ETFs that track a specific index, such as the S&P 500.

Passive investing can be a good choice for investors looking for long-term growth and willing to accept market volatility.

Smart Beta

Smart beta is a strategy in which an ETF is designed to track an index weighted differently than a traditional market capitalization-weighted index.

These ETFs use alternative weighting methods, such as fundamental indexing or equal weighting, to achieve better risk-adjusted returns.

Smart beta may be suitable for investors looking for higher returns but willing to accept higher risk.

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Read this review about VantageFX (Broker)

Risk Management

Investing in ETFs, like any other investment, carries risk.

It's essential to understand and manage risk to achieve your investment goals.

Some key concepts of risk management include:

Diversification

Diversification helps to spread risk by investing in a variety of different securities.

By investing in an ETF that holds a basket of securities, an investor can achieve diversification within a single investment.

Stop-loss orders

A stop-loss order is a type of order that automatically sells a security when it reaches a specific price.

This can be useful in managing risk by setting a price at which an investor is willing to sell a security to limit potential losses.

Position sizing

Position sizing is determining the appropriate amount of an investment to hold in a portfolio.

By determining the appropriate position size, an investor can control the level of risk in a portfolio.

Position sizing can be based on factors such as an investor's risk tolerance and the overall size of the portfolio.

Trading ETFs

Regarding trading ETFs, there are a few key concepts to be aware of:

Online trading platforms

Online trading platforms like brokerage firms allow investors to buy and sell ETFs.

In addition, these platforms provide a range of tools, such as ETF screeners and trading tools, to help investors make informed decisions about which ETFs to trade.

ETF Rule

The ETF rule is a set of regulations that applies to ETFs.

The rule requires ETFs to disclose information about their holdings and net asset value, and it also sets out requirements for the creation and redemption of ETF shares.

Therefore, it’s essential to be aware of the ETF rule and comply with it to trade ETFs effectively.

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Read this review about Exness (Broker)

Key Takeaways

  • ETFs are investment funds that hold a basket of securities and are traded on stock exchanges, providing liquidity and flexibility.
  • ETFs can provide diversification by holding a basket of securities, which can help to spread risk and reduce volatility in a portfolio.
  • ETFs generally have lower expense ratios than traditional mutual funds, which makes them cost-efficient.
  • ETFs must disclose their holdings and net asset value (NAV) daily, providing transparency and accountability to investors.
  • ETFs can be used in various ways, such as for long-term growth, income generation, or to gain exposure to specific markets or sectors.
  • ETFs can be used with different investment strategies such as passive investing, smart beta, and risk management concepts like diversification, stop-loss orders, and position sizing.
  • Online trading platforms, such as those provided by brokerage firms, allow investors to buy and sell ETFs and provide a range of tools, such as ETF screeners and trading tools, to help investors make informed decisions.
  • ETFs are subject to legal and regulatory environments, such as the ETF rule. Therefore, it’s essential to be aware of the ETF rule and comply with it to trade ETFs effectively.

Conclusion

Exchange-traded funds (ETFs) are a powerful investment tool that can provide liquidity, diversification, and cost-efficiency.

This beginner's guide has provided a comprehensive introduction to ETFs, covering everything you need to know to start investing in these versatile financial products.

By understanding the basics of ETFs, the different types of ETFs, and the key concepts of ETFs, you can use ETFs to achieve your investment goals and manage risk.

Additionally, by using the online trading platforms and resources available and understanding the legal and regulatory environment of ETFs, you can make ETF investing more efficient and profitable.

With the proper knowledge and tools, ETFs can be valuable to any investor's portfolio.