Investing in Exchange Traded Funds (ETFs) can be an easy and intelligent way to diversify your portfolio. ETFs work by opening up the opportunity to invest in entire markets, sectors, countries or commodities that are too difficult or impractical for individual investors to gain access to directly. But, what exactly is an ETF, and how does it work?
Exchange-Traded Funds or ETFs are investment funds that own assets such as stocks, commodities or bonds. These trade like shares on the stock market throughout the day – their prices change as they get bought and sold by investors looking to create a diverse portfolio for themselves at low cost.
To invest in an index or commodity; typically, an investor would either need to buy the underlying assets directly (which many people don’t want to do); get exposure through buying futures contracts of these indices, which are complex derivatives with high margin requirements; get exposure through buying into a pooled investment vehicle like a mutual fund which can be very expensive and not practical for might investors, or get exposure through buying shares of an ETF.
The key benefits of ETFs
Here are the key benefits of ETFs;
Security and transparency
One of the main benefits of an ETF is that it tracks an index instead of taking active bets on specific companies. Since this is tracked passively, you are investing in exactly what everyone else invests in, so your return should mirror the market’s returns as a whole. This also ensures transparency; since all information about what they own is freely available, you can make better-informed investment decisions.
Since ETFs are passively managed, they typically have substantially lower costs than mutual funds, which are actively managed. Lower fees mean higher returns for you.
ETFs are easily tradable, and you can buy and sell them throughout the day in the stock market.
Low minimum investment requirement
Most ETFs have a minimum initial investment amount of only a few hundred dollars. This makes investing accessible to almost anyone.
Tax Efficient and effective portfolio allocations
Because ETFs own assets directly, you do not incur capital gains taxes when buying or selling shares in an ETF, unlike with mutual funds, where trading buys/sells shares in companies held by your fund for you at a much higher cost. Also, ETFs can be a very effective way to get exposure to specific markets (e.g. Emerging Markets), which are typically complex and costly to invest indirectly for many investors.
ETFs Vs Mutual Funds
What are the differences between ETFs and mutual funds?
Passive vs Active Management
ETFs track an index passively instead of trying to beat it as mutual funds do. ETFs generally have much lower fees than mutual funds by tracking an index, which helps create higher returns for you.
Because ETFs are bought and sold throughout the day in the stock market, they are easily tradable, unlike mutual funds where you buy or sell them at the end of day NAV prices that cannot be traded unless you sell your entire position not practical for most people.
ETFs are much more tax-efficient than mutual funds, where you pay capital gains taxes when buying and selling shares. This is because ETFs trade like stocks in the stock market, so you do not incur this tax at purchase time; however, with mutual funds, since they buy or sell assets held by your fund for you when you trade so taxes are incurred at the purchase price.
Most mutual funds have an initial investment minimum of $1,000, whereas most ETFs require only a few hundred dollars.
As seen in the above article, there are many benefits to investing in ETFs instead of mutual funds. By cutting down on management fees and taxes, you can make more returns for yourself which will help you make more money in the long run. Beginner traders should use a reputable online broker from Saxo Bank; you can check here for more information.