How ETF Trading Works

how etf trading works
Exchange Traded Funds are one of the best ways to diversify your investment portfolio as provide exposure to a multitude of different markets and industries – but then, so do mutual funds.

So if you were to choose one over the other, how would you go about it?

Of course, you could invest in both simultaneously if you have an ample of amount of dough to spend. However, that is not the case with a lot of traders.

So in this article, we try and explain the reasons why you might fancy investing in ETFs over any other alternative.

As far as investment portfolio diversification and exposure goes, we often see ETFs and mutual funds being listed alongside each other as very strong investment strategies.

That is because, in a number of key ways, they are quite similar. But crucially, in a number of key ways, they are also very different.

ETFs trade in the same way as stocks do and can be traded any time during the day. That affords them with a number of attractive qualities that mutual funds simply do not have.

Reasons to Invest in ETFs

Here are some of the key reasons why you would want to invest in ETFs exclusively.

1. Flexibility

ETFs cover a wide variety of markets and industries. In fact, some of them even represent the economy of an entire nation. The main benefit of this kind of diversity is that it effectively allows investors to ‘hedge’, relying on one investment to compensate for the risk associated with another.

But it is not merely with investing that ETFs offer flexibility. That quality is also present in the transactions. Since ETFs trade like common stocks, there are no time constraints on when they can be purchased or sold. To put that into context, if you wanted to short sell a mutual fund, you could be liable to pay penalty which could be as high as 1% of your initial investment. And the early sale period could be as long as 90 days after the purchase.

2. Low expense ratios

Owning and managing an ETF can be remarkably less costly than doing the same with a mutual fund. One study shows that in most categories, ETFs have expense ratios that are lower than mutual funds.

That said however, investors who prefer mutual funds will point out that the sum of commissions for all transactions combined with the scale of the bid-ask spread is enough to nullify the benefit of having a low expense ratio. Incidentally, these are both costs that do not apply to mutual funds.

3. No minimum purchase

If you have had prior experiences with investing in mutual funds, you will be aware that a lot of them have a minimum purchase amount which can be anywhere between $100 and $3000, maybe more. In fact, it is not unheard of for a minimum purchase to be as high as $50,000.

Fortunately, there is minimum purchase amount attributed to ETFs. You can literally invest in one share at a time if you want to.

4. Lower taxes

Once again, ETFs out-cheap mutual funds when it comes to capital gains taxes mainly because of the way each trade is structured. With a mutual fund trade, capital gains taxes are applied immediately whereas with ETFs, those gains are not realized until after the securities are sold along with the whole fund. That makes them a lot more cost-efficient when it comes to taxes.

5. Derivatives

When managing your portfolio, it is important to focus on risk management as well as diversification. A lot of ETFs offer plenty of useful tools to control risk including futures contracts, options, and swaps. So chances are, you can find a fund where you can hedge your bets with call or put options, or trade with option straddles.

However, some ETFs do actually contain options and futures in which case you should find out about how they may affect your trading strategy and the amount of risk involved.

Conclusion

These are just some of the many benefits you can have by trading ETFs over their alternatives. These benefits have been a driving factor in the popularity of ETFs since the early nineties and they continue to be so even today.


Page Updated: April 20, 2018

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