Updated: Oct 29, 2021
Many people are looking for ways to increase their financial literacy, but it can be overwhelming knowing where to start. In our experience, investors with some degree of familiarity with basic investment concepts have better long-term results and reduced anxiety when the markets are volatile. We like to look at significant investment categories like tools in a toolbox. You first need to understand your financial planning goals to know which tools to select for the job. In our toolbox series, we will cover several of the investment tools available and highlight what role they may play in your financial plan. As you know from DYI projects at your home, having the right tool can make the job go much smoother. The fourth investment tool we will be covering in our toolbox series is an exchange-traded fund or ETF, so let's jump right in.
What Is an Exchange-Traded Fund?
An exchange-traded fund (ETF) is a type of security that holds multiple underlying investments and tracks an index, sector, commodity, or another asset. This can be especially appealing to investors looking to diversify their portfolios. Furthermore, ETF's can be bought and sold on a market, unlike mutual funds. This means that they can be bought and sold during the trading day, just like a stock. An ETF may be set up to track anything from a single commodity's price to a vast and varied group of assets. ETFs can even be built to follow specific investing strategies. One well-known example of an ETF is the SPDR S&P 500, which tracks the S&P 500 Index. ETFs have gained popularity with investors over the past decade with over $8 trillion now invested in these funds.
How Exchange-Traded Funds Work
With an ETF, the fund provider holds the underlying assets, creates a fund to monitor their performance, and then offers investors shares in the fund. An ETF's shareholders own a piece of the fund but not the underlying assets. Nonetheless, investors in an ETF that tracks a stock index may get lump dividend payments or reinvestments from the index's holdings. When observing how ETF’s work, you will find that an ETF may be purchased and traded on an exchange, just like a company’s stock. Furthermore, an ETF, like a stock, has a ticker symbol, and intraday price data is easily accessible throughout the trading day.
Taxes of Exchange-Traded Funds
Due to their unique structure, ETFs generally receive preferential tax treatment over mutual funds. ETFs generate and redeem shares through in-kind transactions rather than sales. As a result, fewer taxable events are generated. When you sell an ETF, however, you create a taxable event. The length of time the ETF was held determines whether it was a long-term or short-term capital gain or loss. In the United States, you must hold an ETF for more than one year to qualify for long-term capital gains treatment. Short-term capital gains treatment applies if you hold the security for one year or less. Furthermore, ETF dividends and interest payments are taxed similar to the income from the underlying stocks or bonds they hold.
7 Types of Exchange-Traded Fund
Investors may choose from a variety of ETFs that can be used to meet their specific needs. Their multiple uses include things like income generation and offsetting risks in a portfolio. Below are just a few examples of the various types of ETF's:
Stock Exchange-Trade Funds: ETFs that track an index of stocks are known as stock ETFs. You can invest in ETFs that cover huge companies, small companies, or stocks from a particular nation. Stock ETFs also allow you to target industries performing well at the time, such as technology or construction.
Commodity Exchange-Traded Funds: An exchange-traded fund (ETF) that invests in actual commodities such as agricultural goods, natural resources, and precious metals is known as a commodity ETF. Commodity exchange-traded funds are popular because they allow investors to gain exposure to commodities without learning how to buy futures or other derivatives.
Currency Exchange-Traded Funds: A currency exchange-traded fund is a pooled investment that gives investors exposure to foreign exchange and currencies. Investors can profit from fluctuations in the exchange rates of one or more currency pairings. Currency ETFs are subject to macroeconomic risks, such as geopolitical concerns and interest rate rises.
Inverse Exchange-Traded Funds: An inverse ETF is a type of exchange-traded fund (ETF) that profits from a drop in the value of an underlying benchmark by employing different derivatives. Inverse ETFs are comparable to short positions, which entail borrowing assets and selling them in the hopes of repurchasing them at a reduced price.
Actively Managed Exchange-Traded Fund: An actively managed ETF is a type of exchange-traded fund in which a manager or team decides the underlying portfolio allocation. An actively managed ETF, in general, does not follow a passive investing approach. A benchmark index will exist for an actively managed ETF, but managers may vary from it as they see suitable.
Bond Exchange-Traded Funds: Bond ETFs are exchange-traded funds that invest in fixed-income assets such as corporate bonds and government bonds. They are often a low-cost alternative for ordinary investors to obtain passive exposure to benchmark bond indexes. Bond ETFs are offered for Treasuries, corporates, convertibles, and floating-rate bonds, among other bond types.
Leveraged-Traded Funds: Leveraged ETFs use derivatives to generate returns that correspond to a multiple of an index return. For example, an ETF might provide a return of 2 times the S&P 500 index. Keep in mind, these ETFs also carry higher risks because they also will multiply any losses that are incurred.
How to Buy Exchange-Traded Funds
Exchange-Traded Funds trade through online brokers and traditional broker-dealers. Which route you chose to take is a matter of personal taste. Traditional brokers may provide clients with assistance and advice, and they typically come to know their clients well over time and offer highly personalized services. To preserve this relationship, those who believe that such engagement is advantageous prefer to work with a traditional broker. On the other hand, online brokers are typically less hands-on with their clients. Those who prefer to take complete control of their portfolio with the occasional guidance tend to choose the online broker route.
Schedule A Consultation with an Experienced Financial Advisor
Here at Fourth Avenue Financial, our first priority is your overall financial success. We want to help you develop, implement, and monitor a strategy that's designed to address your individual situation. If you are ready to start planning for your financial future, we are here to help. Contact us today at (304) 746 7977 to schedule a meeting with one of our experienced financial advisors or schedule online: https://calendly.com/fourthavenuefinancial/introductory-zoom.