ETF stands for Exchange Traded Fund. ETFs are a very exciting and fast-growing segment of the investment industry and appear destined to replace mutual funds as the preferred vehicle for fund investing. They have been available since the early ‘90s, but are now growing at a geometric rate as more and more investors and traders become aware of the profit potential awaiting them with ETFs.
An ETF is a fund comprised of a group of stocks, bonds, or other investment vehicles similar to a mutual fund. However, unlike a mutual fund, ETFs trade like stocks, allowing a trader to buy and sell during normal exchange trading hours. That means you can have immediate access to your funds upon selling an ETF position during normal market hours, anytime you want. In addition, ETFs are generally more cost and tax efficient than mutual funds. However, when trading ETFs, there is a commission that costs the same as you would have when trading stocks. There are no minimum buy or holding period requirements common to many mutual funds. In fact, you can buy as little as 1 share of an ETF as you would buy 1 share of a stock. And so, ETFs are an excellent trading vehicle, whereas mutual funds are not. So that means you can get the diversification that a fund has to offer without giving up the ability to trade in and out of the fund. This is a big deal because you can, virtually, eliminate stock-specific risk by trading a basket of stocks within the fund so that if one stock in the fund suddenly drops in price, the negative impact on a position you may have in the fund would be far less than if you had owned a position in the shares of that particular stock.
There are many different types of funds available. In fact, in the United States alone, there are now over 600 funds currently, and more are being added each day. ETFs include stock sector, country, currency, commodity, bond or other investment-objective related funds. In addition, there are funds that have only short positions, and are sometimes referred to as “short funds” or “short ETFs”, which will increase in price as the short positions they hold go down in price.
Some funds are leveraged funds, meaning that when the stocks in their funds go up by, say 5%, the fund could go up by 10% and short funds whose stocks go down in price by, say 5%, could go down 10%.
ETFs are also a growing investment vehicle in international stock markets as well. A prospectus on each ETF is available and information on the individual holdings of an ETF can be found on Yahoo Finance and other financial related websites. Not all ETFs, however, are suitable for trading, as many are thinly traded or too volatile to be considered good swing trading vehicles.
ETFs in the U.S. are created and maintained by sponsor companies, subject to the approval and regulation of the Securities and Exchange Commission. ETFs are also traded on stock exchanges around the world, such as the London, Toronto, and Australian stock exchanges. These exchanges are approving new ETFs at a rapid pace as they follow a similar growth curve as in the U.S.
In addition to the major exchanges mentioned above, ETFs are also available in the following markets:
- India
- Sweden
- Finland
- Singapore
- Hong Kong
- South Korea
- Japan
- Turkey
The main advantage to trading ETFs, as opposed to the trading of some of the securities in the ETF directly, is diversification. Let’s say you feel that oil and gas stocks are a good buy, but are concerned about buying just one or two companies that could face an unexpected downturn in price due to some specific company related problem – by buying an oil and gas related ETF instead, you dramatically minimize the stock-specific risk because you are buying a basket of stocks, not just one or two.
Another example is, let’s say you feel that the U.S. dollar will continue to weaken against the Euro, you could buy an ETF fund that holds Euro-denominated assets instead of buying a Forex or futures position.
Most, if not all, online or discount brokers (regulated by their country’s regulatory body) that are suitable for stock trading are also suitable for ETF trading. The broker treats them both the same since ETFs trade just like stocks. It is a good idea to use one of these brokers to minimize transaction costs (commissions) when trading ETFs.
As a general rule, ETFs also pay dividends. When the companies owned by the ETF pay dividends, the ETF shareholders are entitled to those dividends. However, ETFs pay out those dividends according to different schedules. Some pay when one of their company holdings pays, others pay quarterly, others according to various schedules.
Some ETFs, on occasion, do have capital gains distributions, but only for extenuating circumstances. As a rule, most ETFs do not make capital gains distributions because they do not have to sell stocks in the fund to redeem shares. So, essentially, the tax implications of trading ETFs are the same as for trading stocks.
In practice, you can buy as little as 1 share of an ETF, so there is no minimum account size, per se, required to trade ETFs, unlike the case for many mutual funds. However, each individual must assess his or her own financial circumstances.
A common circumstance is that many beginning traders want to learn how to trade, but have limited cash for trading. The advice I always give is to learn how to trade first, learn and master a good trading method, practice it over and over again with paper trading. You will then own the method for life. That is a big deal that gives you an edge in the markets that most others don’t have. Then, when the cash becomes available, you will be ready.
People with IRAs or other investment accounts may want to follow a strategy of allocating a portion of their account to ETF trading to have the potential of supercharging the returns on the total account; others may elect to trade the entire account. Again, each individual must assess his or her own financial circumstances.