What are ETFs & Why to Trade Them

Fri Dec 11, 2020, 04:48 pm | by Alexis Jurcak | No comments

If you’re new to trading or just beginning you may have never heard of an ETF stock. You may have seen it thrown around on the internet and by fellow traders, but what does it mean? In this blog post we will explore the basics of ETFs; what they are, how they work, the different ETFs that are out there; the pros and cons of ETFs and how they might benefit or hurt you as a trader. This blog post is to help you determine if ETFs are the right way to diversify your portfolio or help you begin trading ETFs. 

What is an ETF?

The acronym stands for exchange-traded funds. So what does this mean? An ETF represents a basket of assets. Basically, that is a portfolio of stocks, bonds, options, and other tradable assets. that are put together by a professional money manager and put on the stock exchange for investors to buy and sell quickly.  

When you’re investing in an ETF you’re investing in multiple companies that represent or mirror an index. For example, if you were interested in investing in the S&P 500, you don’t actually invest in the index itself. Instead, you would invest in an ETF that represents a portion of that index. The ETF for the S&P 500 is “SPY”. When investing in SPY, instead of buying all 500 companies that the S&P represents you are participating in that index at a fraction of the cost. 

There are two main types ETFs, “Market” or “Index” ETFs. Like the name suggests, Market ETFs or Index ETFs replicate the index of a market. There are different ETFs for the different indexes. For example, as talked about earlier, the S&P 500 is known as SPY  and the NASDAQ 500 is referenced as QQQ. 

The second type of ETFs is known as Sector ETFs. These let you invest in specific sectors of the markets such as healthcare, or tech stocks. Like the Index ETFs each sector is represented by a unique ticker. So, for investing in the healthcare sector the ETF would be represented as XLV. 

What Makes Them Different from Mutual Funds: 

Although ETFs have basic similarities to the two and can often be very comparable, they do present slight differences. 

1. Unlike mutual funds, ETFs can be traded throughout the day versus only being able to trade at market close. 

2. They also present lower fees than mutual funds. Generally, mutual funds charge a 1.42% fee while fees on average for ETFs are 0.53%. Further,  the total price you pay for ETFs is the share price times the number of shares. Basically, you can’t place an ETF order for a dollar amount as you can’t place a mutual fund order for a number of shares.

3. ETFs take about 3 days to settle versus the 1 day it takes for mutual funds. 

4.  Lastly,  minimum investment price of ETFs and the function of automatic reinvesting. ETFs typically have a very low investment minimum compared to mutual funds, and this price depends on what the price of the share is at the time. 

How Do ETFs Work?

Just as you buy a stock on the stock exchange you can buy an ETF on an exchange. Basically, a fund provider considers assets which may include stocks, bonds, commodities, or currencies and creates a basket of them with a unique ticker, just like a stock. Investors buy a share of that basket which can be traded just like a stock on an exchange. 

The Different Types of ETFs

There are 5 different types of ETF investments that you can invest in. 

1. Stock ETFs. These stocks are meant for long-term growth and are less risky than regular individual stocks. They are typically the most common, however, carry more risk than the rest of the investments.

2. Commodity ETFs. These ETFs generally track commodities such as oil, natural resources, and agricultural goods to name a few. 

3. Bond ETFs. These are similar to bond mutual funds in that they hold a portfolio of bonds with different strategies. They’re most commonly used to generate regular cash payments to investors. However, they differ from bond mutual funds because they don’t have a maturity date. 

4. Sector ETFs. As we’ve already touched on briefly, these provide a way to invest in a specific company in one of the 11 sectors in the United States. These are best for those who invest by tracking business cycles yet they carry more risk than broad-market ETFs. 

Pros and Cons of ETFs

Now that you’ve got a basic understanding what an ETF is, you may be wondering what the pros and cons are. 

Pros of Trading ETFs

The number one reason why many traders are drawn to ETFs is diversification. ETF’s have a more stable structure than other stocks. The built-in diversification of ETFs, due to buying into multiple companies across an industry, you have overall less company risk. You don’t have to buy into companies individually. This may be beneficial for those who are beginners, don’t necessarily have the time to do company research, and or are less confident in their abilities to pick stocks themselves. 

Additionally, let’s say you’re investing in SPY, but since it ismade of 33% financial stocks scares you, you can invest in different sectors like the XLV to mitigate the risk of just the financial sector. 

Another reason why many people may prefer ETFs is that they offer transparency. Unlike Mutual Funds, that are disclosed to the public either monthly or quarterly, ETFs are disclosed to the public each day. They are also publicly searchable on the internet for any price activity for a particular ETF on an exchange. 

Cons of Trading ETFs: 

Although they offer lots of diversity, by buying a broad basket of stocks you’re buying winners and losers, meaning whatever you earn is going to be the average of those. Additionally, ETFs are subject to the current market prices while selling since ETFs mirror the index fund; weightage and companies in the index may change which in turn changes our portfolio, and this is out of our control, those that aren’t traded as frequently may be harder to unload.

If an ETF is not traded as often as others it yields less liquidity resulting in problems getting out of the investment. With this, it’s important to monitor the spreads between the bid and ask price to ensure the ETF is liquid enough for your trading strategy. Furthermore, some ETFs don’t bring enough assets to cover administrative costs, meaning you may have to sell sooner than intended, and most likely at a loss. ETFs hold an “operating expense ratio”, which is the annual rate the fund itself charges on the total assets it holds to pay for portfolio management, administrative, and other costs. 

How to Buy and Sell ETFs

Now that we’ve broken down what an ETF is, it’s time to start buying and selling.

1. The first tip to doing so is to think about the time of day you’re buying and selling. Selling/buying early in the morning or at the end of the day could lead to mispricing of securities and you’ll end up paying more than what the basket investment is worth. 

2. When buying or selling it’s important to think about the “order” type you place. The two orders to focus on when doing so are market orders and limit orders.  A market order is an instruction to buy or sell ASAP given the present market price. A limit order is an instruction to trade under a particular purchase/sell price. The other order types are stop, stop limit, and short sale. All of these are to be used depending upon the results you want to achieve. 

How to Stay Up-to-date With the Latest ETF News:

Now that you know what an ETF is and how to buy and sell them, the most important thing to do as a trader is to keep up to date with the changing marketplace. This is easy to do especially with Benzinga Pro. Benzinga Pro offers fast, real-time market news so you never miss out on market movers, including ETFs.

The platform offers tons of different tools to help you make money as a trader. Benzinga Pro’s newsfeed offers customizable filters that allows you to strengthen your investing strategy, real-time audio alerts with our Squawk, and Why Is It Moving alerts (WIIM) to quickly know why a stock is or isn’t moving. 

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Disclaimer: Benzinga is a news organization and does not provide financial advice and does not issue stock recommendations or offers to buy stock or sell any security. Benzinga Pro is for informational purposes and should not be viewed as recommendations. Benzinga Pro will never tell you whether to buy or sell a stock. It will only inform your trading decisions. You can find our full disclaimer located here.