Investments

How Does ETF Make Money

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 13 minute read

The advice to spread your money out is one you hear frequently. The problem is that investing $100 would entail buying 500 shares of stock in large-cap companies, where a single share may cost hundreds or thousands of dollars.

The good news is that you may invest in 500 different firms by purchasing shares of an exchange-traded fund (ETF).

No matter how helpful an ETF may be, you should never put money into something you don’t fully grasp. Even though exchange-traded funds (ETFs) seem like something out of a finance textbook, they are actually far simpler than their name implies and can be understood by anybody with a brief introduction.

Exchange Traded Funds: What Are They?

Exchange-traded funds, or ETFs, are a form of investment vehicle that may be thought of as a “basket fund” because of the wide range of assets it holds.

Mutual funds and exchange-traded funds (ETFs) like the SPDR and SPY can track the S&P 500 by purchasing shares in all 500 firms that make up that index. Indirectly owning a piece of 500 different firms for the price of one share of one of those ETFs.

How close to a mutual fund does it sound? Mutual funds and ETFs both invest in a diversified portfolio of assets, but there are important distinctions between the two.

Similar to the trading of stocks, ETFs are traded in real time on the open market, with investors buying and selling shares directly from one another.

However, mutual fund shares are purchased and sold directly through the fund’s investment advisor. Because of this, exchange-traded funds (ETFs) do not incur the costs associated with a cash reserve, load (buy) fees, or the time and effort of a full-time fund management (passed on to the investor in the form of high expense ratios).

ETFs: How Do They Work?

Providers of exchange-traded funds (ETFs) like Vanguard, Charles Schwab, iShares, and Fidelity purchase up all of the underlying equities. All 500 firms in the S&P 500 would be purchased by a fund designed to imitate the index, as shown above, with the same weighting as the index itself. To a near perfect degree, the fund’s performance will mimic that of the index against which it is measured.

Shares of the fund are traded by investors on public stock markets. For the sake of continuity, if investors drive down share prices for particular S&P 500 firms, the value of the index falls, and investors react by selling shares in the ETF holding those companies, the negative spiral continues.

Keep in mind that ETFs that track the S&P 500 are not directly linked to the index; a decline in the S&P 500 will not necessarily lead to a decline in the price of ETFs that track the S&P 500. Although they don’t always move in lockstep with one another, they do so because they are both driven by the same market factors.

Finally, the price of these funds goes up or down depending on the demand for and supply of shares on the market. Which is reliant on the worth of the assets the funds own.

ETF Varieties

Nearly any goal or asset class may be served by an exchange-traded fund. These are the most typical examples:

  • Long Exchange Traded Funds (Typical Index Funds). These “go long” on a certain stock market index. Index funds are pools of money that invest in the stocks of firms included in a given index in the same weighted proportions as that index. Share prices in long ETFs climb roughly in proportion to the index’s increase, net of fees and commissions.
  • Short ETFs. These exchange-traded funds use short bets against the underlying index, the opposite strategy of long ETFs. ETF share prices are inversely affected by market movements. To put it another way, if the index falls in value, your investment will succeed. For reasons we’ll get into later, short selling carries a higher degree of risk than traditional selling.
  • Exchange-Traded Funds (ETFs) for commodities and precious metals. These exchange-traded funds (ETFs) put money into a variety of commodities and metals. When investing in gold, for instance, an exchange-traded fund (ETF) may own gold equities or claims on physical gold bullion held in trust by a custodian. Those interested in gaining exposure to numerous precious metals or commodities at large can invest in exchange-traded funds. Commodity exchange traded fund (ETF) shares tend to follow the price of the underlying commodity quite closely.
  • Sector exchange traded funds. These ETFs hold a collection of companies from a certain sector, such as the energy and oil sector, the technology sector, the mining sector, the transportation sector, the healthcare sector, and so on.
  • Exchange-Traded Funds that specialize in investing in a specific country or region. These funds purchase stock in firms that together showcase the breadth and depth of a country’s economic landscape. For instance, their portfolio may consist of the 50 most valuable publicly traded companies in a certain country. You may also invest in ETFs that track certain regions within a continent.
  • Exchange-traded funds that use leverage. Leveraged funds “gear up” their holdings with borrowed capital, increasing the potential for profit. Naturally, this also increases the potential for harm. A leveraged S&P 500 ETF, for instance, would aim to provide returns that are about double those of the index after fees and interest are deducted. On the other hand, losses will be magnified by a factor of two when using leverage. However, the lack of loss restrictions makes leveraged inverse ETFs considerably riskier investments.
  • Money market funds. These securities are an attempt to profit from the rise and fall of foreign currencies.
  • Investment funds that invest in bonds. These funds function similarly to stock exchange-traded funds, except that their holdings are in bonds rather than stocks.

Benefits of ETFs

The benefits of ETFs are numerous. They are the lifeblood of many index investors’ portfolios and the bedrock of my own stock holdings. The following benefits of ETFs should be taken into account when you develop and fine-tune your investment and retirement plans.

  1. Diversification

The diversification benefits of investing in an ETF are the same as those of investing in a portfolio of individual assets. One share of an ETF represents a complete investment in all of the underlying stocks and other assets.

As a result, you won’t have to waste time trying to guess the stock market. A convenient option to take part in “the market” generally is to invest in exchange-traded funds (ETFs) that hold thousands of securities to reflect the vast majority of public enterprises in an area.

For instance, my holdings in major global firms are rather modest. Nonetheless, by purchasing international exchange-traded funds (ETFs) that monitor the performance of companies from various nations and regions, I may have access to thousands of overseas shares. Therefore, a shock to a single company, country, or region will not be the sole reason for the decline in my portfolio’s value.

  1. Lower Cost

ETFs provide two methods in which investors can save money compared to mutual funds.
First, if you invest via a brokerage that doesn’t charge commissions, you won’t have to pay anything to purchase shares in exchange-traded funds. Charles Schwab, Vanguard, and TD Ameritrade are just a few examples.

For another, the expense ratios of ETFs are typically significantly lower. Most exchange-traded funds are passively managed, meaning they do not have a human fund manager making investment decisions. The fund’s individual securities are instead managed by an algorithm. Exchange-traded funds (ETFs) that track an index like the S&P 500 simply make the same weighting adjustments as the index as company share prices increase and decrease.

Exchange-traded funds often have considerably lower expense ratios than traditional mutual funds since passive ETF owners do not need to pay a management or team of analysts and brokers to purchase and sell funds on their behalf or manage fund inflows and outflows.

Because even open-end index funds need to retain enough employees on hand to conduct frequent acquisitions and redemptions, closed-end index funds often offer lower cost ratios.

  1. Liquidity

Shares of an open-end mutual fund can only be purchased once a day, at the fund’s NAV as of the previous trading day’s market closing. Day trading is not feasible with mutual funds since you cannot purchase or sell shares throughout the day.

If you buy an open-end fund after hours, and then learn of terrible news when the markets open the next day, you won’t be able to sell it until after 4 p.m. Eastern Time. Likewise, positive news may not warrant a purchase. The next day’s purchase orders aren’t processed until after 4 p.m.

On the other hand, you may use your brokerage account to buy and sell exchange-traded funds (ETFs) and closed-end mutual funds (CEMFs) at any time throughout the trading day. 

To quickly discover a buyer or seller, it helps to know which funds exchange more frequently than others.

It’s important to remember that the liquidity of ETFs changes much like the liquidity of individual equities. The spread between the bid and ask price of thinly traded ETFs is typically rather large. In certain situations, the selling of shares, especially in significant quantities, can lead to a precipitous drop in price.

  1. Transparency

The holdings, trading volume, and price history of an ETF are all available to anybody with a brokerage account. All of this is possible in real time without any delays. The specific holdings of a mutual fund are not known when you purchase or sell shares since the fund only has to declare them once per month or quarter.

  1. Ability to Short Sell

Short selling, or borrowing shares and selling them in the expectation of a price drop, is not permitted with open-end funds. In the event of a price decline, the short seller will repurchase the shares from the original owner at the lower price, reselling them to the original owner and pocketing the difference.

However, investors can short sell market segments, sectors, nations, and even whole markets by employing exchange-traded funds (ETFs).

It’s important to note that only seasoned traders should engage in short selling. If you are wrong and the share price goes up instead of down, your losses might be unlimited. Investing in securities the conventional way means you can lose no more than your initial investment.

  1. Tax Benefits

It is recommended to hold index funds, including ETFs, in taxable accounts due to their favorable tax treatment. This is due to the fact that managers of actively managed funds often sell securities and acquire new ones, whereas portfolio turnover is minimal in index funds.

Whenever a security is removed from an index, an index fund or exchange-traded fund (ETF) will sell those shares and purchase equivalent new securities. If the relative importance of different stocks changes, the only thing that changes is the percentages.

Investors in a mutual fund will be subject to capital gains tax if the fund realizes a gain on the sale of a security. The few share sales of index funds and ETFs mean that shareholders almost never get a taxable payout from these investments.

Distributing “in-kind” to shareholders is another way for the brokerage offering ETFs to save money on taxes. This allows the fund to distribute portfolio assets directly to investors, who may then sell them for immediate cash. The remaining shareholders of the fund benefit from this since it reduces their exposure to the sale’s tax implications.

Investors should be aware that, like closed-end and open-end mutual funds, dividend income generated by an ETF’s portfolio is subject to taxation.

  1. There is no cash drag.

When selling, ETFs are not obligated to make a direct distribution to shareholders (known as redeeming shares). This is due to the fact that when you sell shares of an ETF, you are actually selling them to a third party buyer on the open market.

The fact that ETFs are not required to issue redemptions means that they can operate with very little cash on hand. Most investors always have all their money at work, which allows them to more precisely match the performance of an index and to profit more from rising markets.

Moreover, the long-term average performance of the market has been positive throughout history.

However, having a little amount of cash on hand might damage the fund in volatile market conditions. In the absence of a cash reserve, the portfolio takes the entire hit during a market drop.

In this way, during bull markets, ETF investors profit from the fund’s decision to not keep a large portion of its assets in cash.

ETFs Drawbacks

There are risks associated with every asset class. The following disadvantages of ETFs should be considered with the aforementioned benefits when contrasting ETFs with mutual funds.

  1. Liquidity Concerns

Some exchange-traded funds (ETFs) are more liquid than others, as we’ve seen. Buy orders can drive up the price of a thinly traded ETF, while sell orders can drive down the price. Although fast purchases and sales are still possible, they may not be at the current market price.

  1. Higher Cost for Actively Managed Funds

To use a passive index fund analogy, not all ETFs qualify. It is the goal of the management of some exchange-traded funds to outperform the market.

These actively managed funds are more expensive because of the human effort needed in maintaining them. More specifically, the management fee paid by shareholders each year makes up a larger portion of their expenditure ratio.

  1. Simple Method to Earn Market Average Returns

Although not all ETFs are index funds, you may invest in a diverse portfolio of stocks through an exchange-traded fund. Further, index funds provide a convenient approach to achieve returns that track or even exceed the performance of a certain stock index.

When buying an index fund, buyers are essentially “investing in the market itself.” Investments in index funds that mirror the S&P 500 will increase by the same amount. However, this means that investors will likely only get mediocre returns, rather than the higher rates of return they seek.

To achieve superior returns, investors employ a wide variety of strategies, such as market timing, stock selection, and actively managed mutual funds. However, the approach of buying passive index funds and keeping them for the long term ignores the need to be wise and instead seeks to simply ride the market higher.

I gave up attempting to outsmart the market and prove my intelligence after I had been at it for years. It was too much trouble. However, many investors find that settling for even ordinary returns on their investments is boring.

  1. Small Savings

Share prices are set by investors themselves rather than the fund firm when shares are exchanged on the open market. The value of the portfolio may be greater or lower than the current market price.

Investors in closed-end funds can occasionally purchase fund shares at a discount of 5% to 15% below the fund’s net asset value, while still receiving 100% of the fund’s dividends, interest, and capital gain potential when discount levels improve.

However, savings on ETFs are often very small or nonexistent. If you’re looking to save money on your investment, a closed-end mutual fund managed by professionals is a better option than an exchange-traded fund (ETF). True especially for those looking for a steady stream of income from their investments.

  1. DRIPs are not always accessible.

The DRIP, or dividend reinvestment plan, allows shareholders to have their dividends automatically reinvested in more fund shares. However, not all brokers or funds permit this because it may increase the workload for fund administrators and hence, the expense of the fund.

ETFs make sense as an investment vehicle in large part because of their low expense ratios. When investing in an ETF, it’s important to verify whether or not dividends may be reinvested mechanically. If you don’t have an IRA or other tax-advantaged account, your dividends and interest payments will be sent to you directly, and you’ll have to pay taxes on them.

Should You Invest in ETFs (Exchange Traded Funds)?

I believe that exchange-traded funds (ETFs) should serve as the backbone of every investor’s stock portfolio.

These investments might include a wide range of geographical areas, sectors, and commodities. Every type of mutual fund, from the largest to the smallest, is available for purchase. You won’t even need to look at individual stocks.

Thanks to the variety of options and high level of accuracy, investors may create a portfolio with low correlation between its components. In other words, when one element of your portfolio experiences volatility, the rest of it will likely also experience volatility. Overall portfolio volatility is lowered and downside risk is mitigated as a result.

ETFs are great long-term investments because of the compounding effect of the fees and expense ratios you’ll save by using them.

In reality, most robo-advisor portfolios are built on the stability of ETFs. Investing and saving may be fully automated with the help of robo-advisor systems like Acorns, SoFi Invest, or Schwab Intelligent Portfolios. After opening an account and answering certain questions, the robo-advisor will recommend an asset allocation, often made up of exchange-traded funds (ETFs) that provide diversified market exposure.

Bottom Line

Like any other form of investing, ETFs include some degree of risk despite their many advantages. That risk must be understood, along with past results.

Talk to a financial advisor or sign up for a robo-advisor and review their portfolio suggestions before you invest your life savings. Further, you shouldn’t be bashful about conducting your own research on potentially promising investments.

One that reflects a diverse selection of U.S. large-cap companies (like a fund matching the S&P 500), one for U.S. small-cap stocks (like a fund mirroring the Russell 2000), and one for overseas equities are all good candidates for your portfolio.

Of course, you may go even farther if you’d like to, such as by diversifying your investments abroad to include both established and developing economies. However, when starting off, it’s best to keep things straightforward and varied, both of which may be accomplished using ETFs.

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