Exchange-traded funds (ETFs) are securities that are similar to index funds, with the unique ability for investors to buy and sell them during the day like common stocks. ETFs ultimately give investors an easy method of buying a variety of securities through a single purchase, with about as much diversification as a mutual fund while remaining more convenient.
How You Can Invest in ETFs
ETFs are among the most innovative and well-known securities to appear in the market since the mutual fund’s first appearance. ETFs first began in 1993 with the Standard and Poor’s Deposit Receipt, commonly called SPDR or “Spider.” Spiders allowed investors to imitate the S&P 500 without the necessity of an index fund. Their behavior is also similar to stocks, which means that people can buy and sell them daily, short them, or purchase them on margin.
One thing that investors need to keep in mind is that ETFs don’t sell shares straight to investors, but instead sponsors sell large blocks of 50,000 or more shares called “creation units.” An authorized participant then purchases those, including market makers, institutional investors, and specialists who place them in a trust before splitting them into ETF shares and selling them on a secondary market.
Investors typically sell ETF shares to other investors in the open market, but investors can also collect them and redeem them for a single creation unit, using it to profit on underlying securities. However, the latter decision is rare because of the large amount of shares that can be difficult to manage.
Benefits of ETFs
ETFs have experienced an increase in popularity in recent history, and the number of offerings has grown. There are many reasons for people to use ETFs, such as:
Unlike traditional mutual funds, investors can buy and sell ETFs at any time during a trading day, with trading volumes in the hundreds of thousands to millions.
Many traditional mutual funds often result in capital gains taxes because of the need to sell portfolio assets. On the other hand, buying ETFs in the open market don’t experience any added tax liability, and payoff for redemptions is in stock shares instead of cash, meaning minimal tax burden. Another advantage is that ETFs are paid with the lowest-cost-base shares in the fund, minimizing capital gains.
Lower Overall Cost
What also sets ETFs apart from traditional mutual funds is the fact that they have no front- or back-end loads that you’d normally experience. They are also less expensive because they aren’t actively managed. The lack of minimum investment requirements also makes them ideal for smaller investors who might not want to spend as much on shares.
It’s important to weigh in the disadvantages of ETFs as well. There are two main issues that you should be aware of: If you prefer active management, you’ll likely want to stay away from ETFs because they are typically fixed, and each ETF purchase also comes with a brokerage commission when traded as stocks, which could become a financial hindrance for some.
Based on the advantages and disadvantages of using ETFs, investors can look at both and determine if ETFs are the right investment for them.