Exchange traded funds are collection of securities like stocks, bonds or currencies which are part of an underlying index.
However, unlike mutual funds, these funds are listed on a stock exchange and can be traded online during trading hours.
Since exchange traded funds are not actively managed by any fund manager, they have lower expense ratio than actively managed funds.
Comparison Of Exchange Traded Funds
Comparing and investing in best ETF requires good amount of research and analysis. In this section we will compare exchange traded funds with other investment options.
- ETF vs Mutual Funds
- ETF vs Index Funds
- ETF vs Managed Funds
- ETF vs Open End Funds
- ETF vs Closed End Funds
- ETF vs Hedge Funds
- ETF vs ETN
- ETF vs ETP
- ETF vs Derivatives
- ETF vs Stocks
- ETF vs Bonds
- ETF vs OTC
- ETF vs Unit Trust
- ETF vs LIC
ETF vs Mutual Funds
Mutual funds collect money from investors and invest in various securities. There are mainly three categories of mutual funds – stock funds, bond funds and balanced funds.
Mutual funds are actively managed by fund managers where as exchange traded funds are passively managed. Due to this mutual funds have higher expense ratio.
ETF vs Index Funds
Index funds and exchange traded funds have similar investment strategy as they both invest in securities which are part of a benchmark index like stock index or bond index.
However, index funds are not listed and cannot be traded intraday on any exchange. Due to this there are no trading costs associated with index funds.
ETF vs Managed Funds
Managed funds are actively managed by fund managers who charge management fees from investors. Hence actively managed funds have higher expense ratios.
Mutual fund managers do the research and analysis and invest in best performing stocks or bonds. This gives managed funds an advantage as they have potential to give higher returns to investors.
ETF vs Open End Funds
Open end funds can be bought and sold at any time of the day but they are not traded on any exchange. The NAV of open end funds is calculated at the close of every trading day.
Open end funds do not have any fixed maturity period and are best for salaried investors who can invest the money via Systematic Investment Plan (SIP).
ETF vs Closed End Funds
Closed end funds are launched through an IPO or new fund offer to raise money from investors. Once they are launched, they can be traded on exchanges.
Closed end funds have fixed maturity period and investors are not allowed to redeem the funds before the maturity period. This gives the portfolio manager an advantage to formulate best investment strategy for the fund.
ETF vs Hedge Funds
Hedge funds are similar to mutual funds in many aspects as they pool the money from various investors, are managed by hedge fund manager and invest the money in different securities.
However, hedge funds are not open to most of the retail investors. Due to their requirement of higher minimum investment, they are only accessible to qualified investors.
ETF vs ETN (Exchange Traded Notes)
Exchange traded notes are structured investment products that contain debt notes which are issued by any major bank. ETN are quite secure products as they are backed by major banks with good credit rating.
ETN are unsecured debt notes. Just like a bond, ETN can be held till maturity or it can be bought or sold to the underwriter or any other investor before maturity period.
ETF vs ETP (Exchange Traded Products)
Exchange traded products are financially engineered investments that track underlying index, securities or other financial instruments. The price of an ETP is calculated with reference to the underlying asset.
All the ETP are traded and quoted on stock exchanges and their price fluctuates intraday. Inverse ETP deliver the opposite performance of the underlying security.
ETF vs Exchange Traded Derivatives
Exchange traded derivatives are financial instruments whose value is derived from an underlying asset. This underlying asset can be a stock, bond, commodity or currency.
The most popular ones are futures and options. They can be traded on exchanges which provide liquidity, standardization and elimination of default risk.
ETF vs Stocks
Stocks are issued by companies and they represent part of that company. Companies can issue common stocks, convertible stocks or preferred stocks. They also pay regular dividends to investors.
The advantage of exchange traded funds is that they provide diversification by investing in basket of stocks. Hence they help in reducing the portfolio volatility.
ETF vs Bonds
Bond ETF invest in government bonds, municipal bonds or corporate bonds and they provide diversification, ease of trading and price transparency.
Disadvantages of investing in individual bonds include poor market transparency, higher markup, wider bid ask spreads and poor liquidity.
ETF vs OTC (Over The Counter)
Exchange traded products or listed securities are financial instruments which are traded on exchanges where as OTC products or unlisted securities are not traded on any organized exchanges.
OTC products derive their value from underlying securities like stocks or bonds or currencies. OTC products are best suited for investors who want customized pricing or maturity or quantity.
ETF vs Unit Trust
A unit trust or unit investment trust is formed when the sponsor of the fund buys a portfolio of securities and then sells the units. These units are sold to investors and they have a set liquidation date.
Unit trust is more like a closed end mutual fund but it does not actively manage the securities. The capital gains, dividends and interest income are directly shared with investors.
ETF vs LIC (Listed Investment Company)
Listed investment companies are created by issuing an IPO and collecting fixed amount of money from investors. This money is then used to buy shares of other listed companies.
LIC are like managed funds but they trade on stock exchanges like other listed companies. They are actively managed and pay regular dividends to investors.
Advantages Of ETF
- Trading Flexibility
- Tax Benefits
- Portfolio Diversification
- Cost Effectiveness
- No Minimum Investment
Traditional mutual funds can be traded only once a day and the trading is done with the mutual fund company. Investors have to wait till the closing hours to know latest NAV at which they can buy or sell mutual funds.
Exchange traded funds can be traded intraday like stocks during market hours on any exchange. You don’t have to wait till the closing hours to know the latest price. This is a very important benefit when the underlying volatility is very high.
This is one of the biggest advantages of exchange traded funds over traditional mutual funds. Due to structural differences exchange traded funds are more tax efficient than mutual funds. Investing in ETF can reduce your tax and increase your long-term investment returns.
Regular mutual funds have to pay capital gains taxes as the shares in those funds are traded throughout the life of the investment whereas ETF investors have to pay capital gains tax only when you sell them.
By definition, exchange traded funds invest in a collection of stocks or bonds or currencies. There are hundreds of ETF trading on stock exchanges covering different varieties of diversification.
- Diversification across different indices or sectors or commodities
- Diversification on the basis of market capitalization like small cap, mid cap or large cap funds
- Diversification across different investing strategies like value investing or growth investing or dividend reinvesting
- Diversification across regions like developed or emerging countries
- Diversification across different fixed income maturities like long term or short term bond funds
- Diversification across various types of bonds like treasury, corporate, junk or high-yield
Most of the traditional mutual funds are actively managed. Fund managers have a team of analysts and research professionals which make real time investment decisions.
Due to this actively managed funds are subjected to higher management fees and this leads to higher overall expense ratio for such mutual funds.
Exchange traded funds are passively managed and they do not have to go through the stock selection process. Therefore they have lower expense ratio and are more cost effective than mutual funds.
No Minimum Investment
Most of the mutual funds require minimum investment of $1000 or $2000. Since ETF are traded like stocks, there is no minimum investment required and you can purchase as low as one share.
You can take a small position in any fund or you can scale in and scale out of existing fund without worrying about the minimum investment limits.
Disadvantages Of ETF
- Over Diversification
- Less Diversification
- Low Trading Volumes
- Tracking Error
- Leveraged ETF
Exchange traded funds are not actively managed and are designed to follow a specific index. Since the underlying index, and hence the ETF, might not contain the very best stocks, it might result in over diversification by compromising the quality of stocks.
It is more advantageous for an investor to own a small number of high quality stocks rather than owning entire index. This is particularly true for ETF which are sector specific or track a very small universe of stocks.
Some investors who invest in sector specific ETF or International ETF might be limited to investing in large cap stocks only. Lack of exposure to mid cap or small cap stocks can result in less diversification and higher concentration in few large cap stocks.
Low Trading Volumes
Although you can buy and sell exchange traded funds intraday on any exchange, not all ETF have high liquidity. Low trading volumes can result in a wider bid ask spread which can reduce the cost effectiveness of investing in exchange traded funds.
ETF managers are supposed to keep the allocation similar to the underlying index. Whenever there is any change to the underlying index, those same changes should be reflected immediately in the exchange traded fund.
However, this might not be as easy as it sounds. The delay in implementing the changes can result in tracking error which can be additional cost to investors.
Although exchange traded funds are less risky, there are certain classes like leveraged ETF which have higher risk compared to other investments. Investors investing in such instruments should take the help of investment advisors and watch their investments carefully on a regular basis.
Different Types Of ETF
- Index ETF
- International ETF
- Inverse ETF
- Leveraged ETF
- Energy ETF
- Currency ETF
- Real Estate ETF
- Commodity ETF
- Stock ETF
- Bond ETF
Index ETF invests in securities which are part of an underlying index and are less volatile than sector ETF. These indexes contain stocks, bonds, commodities or currencies.
These funds have lower cost and expense ratios. The bid ask spread on best Index ETF are very tight, so you can buy and sell them easily and efficiently.
International ETF helps you to diversify your investments by investing in foreign stocks and bonds. You can also hedge your foreign investment risk.
These funds invest either in developed economies or in emerging market countries. Investors would do best by investing in mixture of both.
Inverse ETF are a good way to create short positions. For example, you can create short positions in municipal bonds or corporate bonds by buying inverse bond ETF.
These funds give their best performance during bear markets. You can also hedge your portfolio by investing your money in inverse ETF.
Leveraged ETF are best suited for investors who are looking for advanced trading strategies. You should consult a mutual fund advisor before adding them in portfolio.
These funds provide leveraged daily returns on underlying assets and indexes. They are useful as short term hedges and tactical strategies.
Real Estate ETF
Real estate ETF or real estate investment trust (REIT) invest directly in real estate properties or in the companies that are operating in real estate sector. These funds are best for investors looking for exposure to real estate sector without actually buying any property.
Commodity ETF are of 4 types. Physical commodity ETF, Equity based commodity ETF, Futures based commodity ETF and Exchange-traded notes (ETN).
These funds give you the best opportunity to invest in any commodity like gold or silver without actually buying the underlying commodity.
Stock ETF invest in securities of companies from various sectors. They either invest in preferred stocks, common stocks or convertible securities.
Stock ETF are best for providing long term capital growth. On the basis of capitalization, these funds invest in small cap, mid cap or large cap companies.
Bond ETF invest in government bonds, municipal bonds, corporate bonds, junk bonds, tax free bonds, international bonds, zero coupon bonds, etc.
They are best for investors looking for retirement planning. They can either invest in inflation protected bond ETF or target date bond ETF.
Energy ETF invest in securities of companies from energy sector. These companies are best in producing clean and renewable energy like wind or solar.
Currency or forex ETF provide exposure to foreign currencies. These funds either track a single currency or basket of currencies.