Investing in ETFs for beginners

An ETF (Exchange Traded Funds) can be seen as an collective investment fund which is traded on the stock exchange. It works like a container of assets (as do stocks, commodities or bonds) in which you can invest in order to grow your wealth. These Exchange Traded Funds are very popular as a passive income asset. But what are they exactly? What types of ETFs exist and why would you want to invest in them?

ETF’s are basically an investment vehicle. There are many investment vehicles in which you can put your money and see them grow. ETF’s are one example of such an investment vehicle. Other vehicles include assets such as stocks, bonds, mutual funds and index funds. Exchange Traded Funds (ETF) is one of the most common vehicles, with more than $10 trillion in assets under management. ETF’s can be very much worth it to invest your money in.

Good to know

  • The best performing ETFs have seen results as high as 200% to 600% over the past five years.
  • But as the ETFs industry is so large, most people don’t have a good understanding of what it actually is. This is normal. The financial market space is highly dynamic, with many inventions during the past decades.
  • The most recent invention are cryptocurrencies like Bitcoin and Ethereum, which are not necessarily easy to understand either but have seen the highest returns one can imagine.
  • ETFs have been available in the US since 1993 and in Europe since 1999. Source: Wikipedia.

What are ETFs?

An ETF is made up of three parts. There is the exchange, the traded, and the funds.

  • An exchange is simply a central place where investors do the investments. The most popular exchanges in the US are Nasdaq and the New York Stocks Exchanges (NYSE).
  • The second part is the traded one, which means that investors can buy and sell the ETFs every time the market is open.
  • Finally, a fund is a collection of stocks and other financial assets. Therefore, an ETF can be defined as a fund that is created, listed in an exchange, where investors can trade it.

How ETFs Work

ETFs are formed by large investment companies like MoneyFarm, Vanguard, WisdomTree, and JP Morgan. This process of creating an ETF tends to be a difficult one for most new investors to understand.

Step 1 in creating an ETF

The first process in the creation of an ETF is for the company to come up with the idea of the ETF.

To create the ETF, the company must use an Authorized Participant (AP), who could be a market maker or a large financial institution. The role of the AP will be to acquire the securities the ETF maker wants to make. The AP will then buy all the stocks they have been instructed to do so.

Step 2 in creating an ETF

After doing this, the ETF maker will give the AP a block of equally valued shares, which are called the creation units. In this, the two parties benefit because the ETF provider gets the stocks and the AP gets plenty of ETF shares, which they can sell.

etf for beginners
How ETFs are made. A summary of the creation/redemption process.

Types of ETFs

Broadly, there are two major types of ETFs.

  • Passively managed ETFs are those which track a certain index. These are the most common ones and have more than $3.6 trillion in assets under management.
  • Actively managed ETFs are those that has active managers behind them. These are not very common but have more than $61 billion. These ETFs can then be divided according to the types of assets that they invest in. See below.

1. Equity Funds

These are the most common types of ETFs. As the name suggests, these are ETFs which have bought vast amount of stocks. There are equity funds, which invest in broad types of stocks and there are sector funds that invest in specific sectors. Examples of these are technology ETFs, finance ETFs, and materials ETFs. Examples of the most common technology ETFs are the Vanguard Information Technology ETF and the Invesco Dynamic Software ETF.

Other than sectors, the ETFs can be grouped depending on the size of the companies. In this, there are large cap ETFs, mid & small cap, and large cap value. Further, they can be grouped geographically such as emerging markets and international ETFs.

2. Fixed Income ETFs

These are ETFs that invest in the various fixed income products. The most common of these is the bond funds. These funds invest in government, corporate, and municipal bonds.

3. Commodity ETFs

These are ETFs that invest in the various commodities. The most common commodities are gold, silver, and crude oil. Examples of the most popular commodity ETFs are the SPDR Gold Trust, iShares Comex Gold Trust, and the PowerShares DB Gold ETF.

4. Currency ETFs

These are ETFs that invest in various currencies. Examples of these are the WisdomTree emerging currency strategy fund, WisdomTree Chinese yuan strategy fund, and the Bloomberg US dollar bullish fund among others.

5. Balanced ETFs

These are ETFs that invest in both stocks and bonds. The most common ratio is having 40% in bonds and the 60% in stocks. An example of this is the WisdomTree Balanced Income Fund. There are other types of ETFs like managed futures and those that are options based.

Benefits of Investing in ETFs

There are a number of reasons why most investors are turning to ETFs.

  • First, like index funds, these ETFs provide an easy way to have a diversified portfolio. This is because, as explained, they are made of a group of financial assets.
  • Second, you can easily track the companies that make up the ETF. All funds have a website where you can get all the details you need to know about the ETFs.
  • Third, they are user-friendly, unlike the other mutual funds. This is because they can be bought and sold at any time during the trading day just as stocks do. On the other hand, mutual funds can be bought and sold once. Finally, most ETFs have very low fees compared to mutual funds. On taxes, ETFs are usually better because the fund manager does not need to keep on buying and selling the assets.

Best performing ETF’s

Final Thoughts on ETFs

As an investor with a long-time horizon, we recommend that you invest in various exchange-traded funds. As mentioned, it is a low-cost method of investing in diversified portfolios. As with stocks, you can exit the investment at any time. You will also gain from the dividends that come from the invested companies.

Crispus (BSc and MBA) is a finance professional with more than a decade experience as a financial analyst, writer, researcher, and trader. Crispus has written in-depth articles on leading platforms like CCN, Marketwatch, Investing Cube and Seeking Alpha. He also runs a forex education firm. Follow him on Twitter: @crispusnyaga and read more about us.