The essence of index exchange traded funds (ETF) by examples. How ETFs work and where you can buy their shares. Advantages and disadvantages.
TFGI, a leading independent research and consulting firm, reported that investment in ETFs increased to $ 6.10 trillion. According to Bank of America forecasts, this figure will steadily grow over the next 10 years and will grow 50 times. Capital inflows into ETFs are starting to spill over from mutual funds and for a reason.
You can often hear from experienced investors about the need to diversify their assets. Of course, you can buy shares of different companies, maintain their ratios, carry out regular rebalancing in order to maintain the structure of the investment portfolio, but this requires a lot of time and serious investments. Here exchange-traded funds come to the aid of the investor.
What is ETF (Index or Exchange Traded Funds)
ETF (Exchange-Traded Funds) is an investment fund that copies a basket of some stock index, and the fund's shares are traded on the stock exchange, therefore ETF funds are also called as an index fund or an exchange-traded fund.
For example, the First Trust NASDAQ Global Auto Index Fund copies the basket of the NASDAQ OMX Global Auto Index, which includes the stocks of the 15 largest automakers around the world. The ETF buys shares in the same proportions, completely repeating the price dynamics of the underlying index. The stock index itself is just a calculated number, and the ETF makes it a real asset.
The fund's management company places shares on the stock exchange (hence another name - exchange-traded funds). Buying one share of an ETF fund is like buying a portfolio of shares.
The advantage is that if you separately bought all the stocks from the stock index, you would need more than 10-30 thousand dollars, when as a stock ETF of the fund costs in the range of 40-120 dollars, but repeats the same dynamics. In addition, you are not engaged in portfolio rebalancing, the fund itself is engaged in this, which constantly monitors changes in the index. And this is very convenient, since most of the indices are still large, for example, the S&P 500 with 500 companies in assets.
ETFs are available across a variety of asset classes. Investors can buy funds that target companies with low, medium or high cost of capital, or focus on sectors such as technology or energy.
The value of ETF shares changes depending on the dynamics of the prices of its assets. Thus, buying a share of such a fund, an investor, as it were, invests in all of his assets in shares similar to the fund. In other words, ETFs are, in simple terms, a basket of assets that you can invest in.
For example, the Dow Jones Industrial Average is calculated from the 30 largest US companies. But the index reflects only the calculated number, not a specific asset. SPDR Dow Jones Industrial Average ETF Trust (DIA) copies the composition of the index basket in the same proportions, that is, its assets contain real securities. It would take you a lot of money to buy shares of the 30 largest companies, and by buying one ETF DIA share, you are essentially investing in a ready-made stock portfolio at a much more affordable price.
Examples of the largest ETFs
Currently, most ETF funds in the world are managed by only 3 companies - State Street Global Advisors (SPDR), BlackRock (iShares family of funds) and The Vanguard Group. These financial companies manage thousands of funds and trillions of dollars. Below we will look at examples of large ETFs from various industries.
1. SPDR® S&P 500® ETF Trust (SPY) - one of the leaders in the rating of index funds in terms of assets. The ETF tracks the dynamics of the S&P 500 index and is one of the largest and most popular in the world.
2. iShares MSCI Emerging Markets ETF (EEM) - an exchange-traded fund that tracks the health of the MSCI Emerging Markets Index, which includes stocks of companies from emerging markets.
3. SPDR Gold Shares (GLD) - "Gold" ETF, the largest fund, the assets of which are fully backed by the gold metal.
4. iShares Barclays TIPS Bond Fund (TIP) - fund copying the dynamics of Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index, which includes inflation-protected US Treasury bonds.
5. United States Oil Fund (USO) - an American ETF that tracks the quotes of the Texas WTI crude oil.
6. First Trust NASDAQ Global Auto Index Fund (CARZ) - exchange-traded fund following the NASDAQ OMX Global Automobile Index. His basket includes stocks of companies involved in the production of cars.
7. iShares U.S. Pharmaceuticals ETF (IHE) - the benchmark for the fund is the Dow Jones U.S. Select Pharmaceuticals Index, which includes shares of companies from the pharmaceutical industry.
8. Vanguard Real Estate Index Fund (VNQ) - exchange-traded fund, whose assets include shares of companies from the real estate sector. The ETF follows the MSCI REIT Index quotes.
9. Vanguard Information Technology ETF (VGT) - fund that monitors the state of the information technology market. Its benchmark is the MSCI US Investable Market Information Technology Index 25/50.
10. iShares S&P GSCI Commodity-Indexed Trust (GSG) - the ETF tracks the quotes of the S&P GSCI (R) Total Return Index.
11. Invesco DB Agriculture Fund (DBA) - american ETF, which includes 11 futures for the most liquid agricultural commodities in its assets.
12. Vanguard Small Cap Value ETF (VBR) - a U.S. exchange-traded fund that monitors the small-cap market. The benchmark for it is the MSCI US Small Cap Value Index.
13. PureFunds Drone Economy Strategy ETF (IFLY) - a very unusual exchange-traded fund, which includes shares of companies working in the production and development of unmanned aerial vehicles - drones.
14. ROBO Global Robotics & Automation Index ETF (ROBO) - another non-standard ETF, the list of assets of which includes the securities of companies working in the ecosystem of creating robots.
15. ETFMG Video Game Tech ETF (GAMR) - a fund that monitors the dynamics of stocks, issuers of which are engaged in the development of video games or conduct activities in related fields.
Investing in ETFs helps to significantly diversify the portfolio and gives access to even fairly specific assets.
How much can you earn by investing in ETF?
Investing in ETFs can be good profits. Their main goal is to get a profitability corresponding to the dynamics of the underlying asset minus management fees. Many of the largest ETFs charge less than 0.2% per year for management.
The profitability of index funds can vary greatly depending on the underlying asset and the period in question. The top ETFs with the strongest growth in indices can return 50% per year and more if bought on time. ETFs also have unprofitable months, but in the long term, exchange-traded funds for the world's largest indices still tend to grow.
Over the past year, the SPDR S&P 500 ETF Trust rose by about 15.1%, while management costs were only 0.0945%, that is, the annual return was about 15%.
Growth of 44.1% in 12 months at a 0.2% expense ratio was shown by the Invesco QQQ Trust, becoming one of the best in terms of profitability among large ETFs.
How to choose an ETF for investment?
It is best to start searching for ETF not from the fund, but from the index. After all, it depends on the fluctuations of the index whether the investor will receive his profit or not. Once you have found a suitable index, you can start choosing the best ETF - after all, large indices track dozens of ETFs at once.
Assets size. The larger the fund, the higher its reliability. The probability of closing the largest funds even in times of crisis is vanishingly small, but ETFs that are too small in terms of capitalization and narrow focus can be unpredictable.
Term of the work. The longer the fund has been on the market, the more experience its managers have, and the higher the client's trust in it.
Commission size. As a rule, this parameter closely correlates with the size of assets, because only large funds can afford commissions at the level of hundredths of a percent. Do not forget that even a difference of 0.1% over a long period of time can quite strongly affect the size of the profit due to compound interest.
Liquidity. It can be difficult to sell shares of little-known funds at the right time, which can lead to missing the right time to complete the deal. It is better to give preference to liquid ETFs, especially if we are not talking about investments with a duration of several years.
It is usually quite simple to choose an ETF for a specific index - in most cases, the most favorable conditions are offered by funds in the top ten in terms of capitalization. Index fund rankings and current data, capitalization in billions.
Is it possible to receive dividends on ETFs?
According to the availability of dividend payments, exchange-traded funds can be divided into two main types.
The first type of ETF accumulates dividends received from the issuers of shares, and then distributes them among the holders of their securities at a certain time interval (usually once a month, quarter, six months or a year). The shares of such exchange-traded funds bring their owners regular passive income.
The second type of ETF does not pay dividends received to its shareholders, but reinvests them, adding to its assets, which causes an increase in the value of its shares. Such funds give more profit in the long term due to the work of the compound interest mechanism, but at the same time they do not bring regular income to the holders.
Advantages and Disadvantages of Investing in an ETF
Having understood what ETFs are and how they work, it is worth considering the main pros and cons of such investments. The benefits include:
Diversification. By buying one share of an exchange-traded fund, an investor immediately invests in many individual companies that make up the underlying index, which reduces risk.
Availability. It can take hundreds of thousands of dollars to build a portfolio that tracks an index. In the case of exchange-traded funds, it is enough to purchase just one share in order to be able to make money on the dynamics of the index.
Saving time. Compiling and regularly rebalancing a portfolio of securities that track a particular index takes a lot of time. In the case of ETFs, it is enough to simply buy one share, and the fund's management company will take care of the portfolio structure.
Low costs. Management fees for some large ETFs are less than 0.1%.
Liquidity. Unlike some other financial instruments, stocks of large ETFs can be bought or sold at any time - the demand for them is stable. To open or close your position, you do not need to wait, it is enough to make a deal on the exchange through the terminal.
Diversity. There are many exchange-traded funds on the market that track the quotes of a wide variety of indices, any of which can be profitable.
The disadvantages of investing in index ETFs include:
Lack of guarantees and insurance. The return on investment in ETFs is not guaranteed, since no one can predict for sure how the global or local economy will behave. Investing in ETFs is entirely at your own risk.
In general, the number of advantages exceeds the number of disadvantages, however, each investor decides on the advisability of investing in ETFs independently, based on his own considerations.
There are a number of guidelines that can help novice investors capitalize on ETFs.
Buy shares of large well-known funds. Such ETFs are not only more reliable, but also are among the most liquid, which will allow you to quickly find a buyer for them in almost any conditions.
Buy ETFs at the same time their underlying assets are being traded. This allows you to buy shares at a price closest to their fair value and not lose profitability due to random fluctuations.
Buy what the investor understands. You should not buy shares of a fund investing in unknown companies or obscure assets just because they showed good growth earlier - the bullish trend can end at any time, and only understanding the asset can help determine how long the growth will last.
Use limit orders. It is not always profitable to make transactions at the market price, especially if you plan to buy an ETF that is not the most liquid - the price for it can fluctuate quite strongly, which is why the best choice would be to open an order with a preselected price.
Conclusion
Exchange-traded funds are a popular financial instrument that allows you to purchase a wide range of assets at a relatively low price. Smart investment in ETFs allows you to diversify your portfolio and bring high returns.