We have talked about several investment topics. From celebrities who invest, to applications to invest. In the article “Investment and micro investment Platforms and applications” we briefly talk about ETFs as an investment instrument. But on that occasion, we did not delve into this type of interesting asset. That is why today we will talk about what an ETF is, its characteristics and benefits of this type of financial asset.
ETFs, also known as Exchange-Traded Funds, are among the most diversified and safe investment instruments. They are characterized by bringing together a series of assets with defined characteristics to diversify the portfolio. With this they find the balance between return and security of investment.
Stocks can rise and fall quickly depending on the circumstances. This makes them more volatile assets. You can make a lot of money, but you can also lose a lot of money. ETFs are characterized by not offering large profits, but they do offer us an interesting utility without taking great risks.
Many companies today issue ETFs. But each ETF has characteristics that make them unique and therefore we must study them to choose the best among these. Investing is an art that requires studying the market, but if we do not have to invest indices and ETFs are our best option.
Without further ado, let’s start by knowing what ETFs are.
Table of Contents.
Definition of an ETF
It is an investment fund that brings together a series of financial assets and can be traded on secondary stock markets. At first glance it seems like another financial instrument, but it is not.
The fact that it can be traded in secondary markets means that it can be sold at any time of the day. This is sold at the price that the asset is quoted.
ETFs pool assets according to certain diversification, security, and attribute characteristics. There are ETFs that gather assets that give dividends and there are those that are dedicated to growth companies, where there are no dividends. The characteristics of a particular ETF are chosen by the issuer of it.
ETFs, as if they were a sports team, balance advantages and weaknesses of the stocks that compose it. In this way, balance the risk-benefit. Like indices, it can offer us the best of the market in which it is issued, or of a particular sector.
The diversification of portfolios is their great advantage, but also the ability to market them quickly and their low costs make them incomparable.
But you may be wondering if they really are that different from other financial instruments. And it is that each financial instrument in the eyes of the little connoisseurs can be presented as equals. The truth is that each financial instrument has its own characteristics. These characteristics are not only about performance but about the expectations of resource movement. Therefore, anyone who wants to invest must at least know the fundamentals of the financial instruments in which they want to invest.
Below, we will explain some of the most relevant differences.
Are index funds and exchange-traded funds the same thing?
The instrument most similar to an ETF is index funds. These are investment funds looking to copy a stock index. This makes the calculations to liquidate the index funds and the realization of the operations is made when closing the stock market operation.
In this case, the management effort is focused on improving the performance of the stock market index, and not on the management of daily ups and downs. Thanks to the absence of active management, these index funds have much lower commissions. But finally, what are the differences between the latter and ETFs. Below, we list the differences between both instruments
Differences between an index fund and an ETF
As we mentioned before, there are differences between them that can help us to opt for one or the other. Next, we will mention the most significant differences.
- ETFs pay commission for each sale and index funds charge subscription and redemption fees. Although not all apply the latter.
- ETFs are bought and sold at the value at the time of the transaction. Index Funds are traded at the value that closes the stock index at the end of the day.
- ETF fees are lower than index funds. However, commission is paid every time an ETF is traded. In Index Funds, after subscribing, if you want to make additional contributions you will not have to pay commissions.
- Investment funds can only be contracted through some financial institutions. ETFs, functioning as stocks, can be managed by any broker.
- Index funds are taxed as investment funds. This differs from paying taxes in the long run. On the other hand, ETFs are like stocks, so every time you buy and sell taxes are generated.
- There are many more options to choose from among ETFs. This is because some ETFs focus on some common sectors or features. Index funds only follow indices that already exist. Therefore, there is not much variety in the offer.
Advantages of ETFs
As we can see, ETFs are a great option for investing. But here we are going to explain in a concrete way what are the advantages of acquiring an ETF. ETFs are very powerful financial instruments because:
- They are highly diversified instruments.
- The diversification of the portfolio makes them very attractive because they reduce investment risks.
- Commissions are low.
- They can be traded immediately which means immediate liquidity.
- You can buy ETFs through any broker, so you have a lot of accessibility.
- There is a great diversity of offer that fits your need for investment or interests.
Therefore, we consider ETFs to be a great tool to invest, while mitigating investment risks.
The best ETFs to invest in.
Some of the best ETFs you can invest in are the following:
- INDA (iShares MSCI India ETF)
- QQQ (Invesco QQQ)
- XLC (SPDR-COMM SERV Equity)
- ARKG (ARK Genomic Revolution ETF)
- QEEM (SPDR MSCI Emergin Markets Strategic Factors)
Three ETFs that are very promising for short investing are as follows:
- IJR (iShares Core S&P Small-Cap ETF)
- EWZ (Brazil Index MSCI iShares)
- GLD (SPDR Gold)
Disadvantages of ETFs
ETFs have many advantages without a doubt. However, because they are made up of a significant number of stocks, ETFs have the same weaknesses as the stocks that make them up. This means that we must not only know the ETF and its performance, but we must also know the package of stocks that compose it.
On the one hand, it seems simpler to bet on diversification to have an ETF. However, having a package of actions which we do not know can also become a double-edged sword. That’s why we always urge you to look at what’s in etFs and understand how each of them works.
We must know in depth these instruments, but also know that there are different types of ETFs. Depending on the type of ETF we are handling, we will also have a risk associated with the transaction.
On the other hand, there are disadvantages of ETFs in general as we listed in the next section.
Disadvantages of the ETF model compared to other types of investment
Below, we will mention the disadvantages of investing in ETFs with respect to other types of investment:
- From a tax point of view they have fewer advantages than investment funds: ETFs from a tax point of view behave like stocks. Therefore, when we change our investment from one ETF to another, we must pay the taxes corresponding to the profits. On the other hand, in investment funds moving from one investment fund to another does not imply the payment of taxes because it is assumed that the money remains invested and has not generated profits.
- Transaction fees: Costs are incorporated when making transactions through brokers. That is why we must incorporate these expenses unlike investment funds.
- Very complex product: This is the most interesting, but at the same time the most delicate of ETFs. As we mentioned earlier, it is important to know the instrument in which we invest. But ETFs are not a single group. In this case we must bear in mind that there are different types of ETFs, and therefore we must consider studying them before investing. These differences can increase the risk of losses, as is the case with leveraged ETFs, as we will see in the next section.
- Price duality, gap between supply and demand: ETFs have two prices because this is what makes up supply and demand. Therefore, if the gap is very large, it will be difficult to sell at the price we need. This can mean that despite having won we can lose at the time of selling.
Types of ETFs and level of risk
ETFs can represent an easy way to diversify our portfolio. However, this does not make ETFs fully safe. Therefore, below we will proceed to classify and describe the types of ETFs currently available in the market.
ETFs according to the investment instrument
This first group is classified ETFs according to the set of tradable goods that they include within their offer. This means that they are classified according to the object of investment. In this group we can find the following types:
- Shares: These are those whose composition is based on shares of the stock exchange according to established diversification rules. Some may follow a stock index, a set of companies or a particular sector. Its composition determines the level of risk and its profitability. We must also know the economic situation at the time of carrying out such a liquidation of assets.
- Bonds: These are composed of debt bonds, whether government or companies. They tend to be safer and have lower profitability. However, they are as stable as the companies or governments issuing the bonds they contain. That is why it is convenient to know the internal composition of the ETF.
- Raw materials: They are composed of the price of commodities and their future options. Some may be backed in physical goods such as gold, while others in futures contracts. Those with physical goods are better backed and safer, but with less utility. Therefore, it is convenient to know more about the composition and support of these ETFs.
- Currencies: They are composed of baskets of currencies. While they can be very interesting because of the gains that can be produced by currency changes, economic situations such as the current ones with global inflation can affect the value of the ETF.
As we can see we must know what we invest in.
Are ETFs a good instrument for investment?
Yes of course. But we must still inform ourselves about the options we have. Although ETFs mitigate the risks of investing, we should not fail to be informed. Gustavo Mirabal recommends that we learn the basics of the financial markets to make conscious investments.
But for Gustavo Mirabal, this is one of the safest investments a beginner investor can make. That’s why we recommend that you do a little more research on ETFs. And if you’re feeling ready, start your career as an investor. We are waiting for you again here with the tips to invest from Gustavo Mirabal.