What are ETFs?
ETFs is short for Exchange Traded Funds. They are similar to mutual funds but trade on a stock exchange and can be bought and sold just like individual stocks. As with traditional mutual funds, ETFs invest in many different individual securities. The benefit of ETFs (and mutual funds) is that they provide diversification to investors, which tends to increase returns and lower risk compared to buying any one individual stock.
The benefits of ETFs compared to mutual funds include:
- they can be bought and sold like an individual stock; thus, they can be traded at ANY time of the trading day, risk can be managed by using stop-loss orders, they can be shorted to profit from a decline in price, etc.
- they are often lower cost because they usually have lower expense ratios than mutual funds and no sales loads. However, there are commissions on trades, but those can be minimized using online discount brokers
- they are typically more tax efficient because the fund manager is not required to make trades when ETFs are bought and sold, unlike mutual funds
- they offer nearly infinite choices of investments in virtually all asset classes: there are active and passive ETFs and even inverse and levered ETFs
Different types of ETFs
There are a wide variety of ETFs that are only limited by the imagination of Wall Street. Different types of ETFs include:
- US stocks, including large and small market capitalization, growth and value, various sectors, etc.
- International stocks, including various countries and regions
- US bonds, including US Treasury, corporate and municipal bonds of various maturities and credit ratings
- International bonds, including various countries and regions
- REITs, including various types of real estate
- International REITs, including various countries and regions
- Commodities, including various commodity indexes and individual commodities
- Currencies, including currencies of various countries
- Alternative investments, hedge funds, MLPs (master limited partnerships), etc.
ETFs are either passive or active. Passive stock ETFs are passively invested in the stocks that comprise a given stock market index such as the S&P 500 or NASDAQ 100. For example, an ETF that tracks the S&P 500 index essentially invests in the 500 individual stocks in the S&P 500 in the same percentage weighting that they are in the index (if Apple is 3.6% of the S&P 500 and McDonald’s is 0.5%, a passive S&P 500 ETFs will invest 3.6% in Apple, 0.5% in McDonald’s and so on). The goal of a passive ETF is to generate the returns of the index it represents as closely as possible. Two key benefits of passive ETFs are:
- they never materially underperform the index they are following (but also never materially outperform) and
- they are lower cost than actively managed ETFs, since they can essentially be managed via computer rather than expensive professionals.
Active ETFs are actively managed, which means portfolio managers and analysts pick individual stocks (or other securities) to buy in an attempt to outperform the index they are benchmarked against. The obvious benefit of active ETFs is that they have the potential to outperform the benchmark, such as the S&P 500. The downsides of active ETFs are they have:
- the potential to materially underperform the benchmark and
- higher expenses than passive ETFs, since they have to pay the portfolio managers and analysts for the research they conduct in picking stocks or other securities.
Inverse ETFs are ETFs that use various derivatives like futures and swaps to generate returns in the opposite direction of traditional ETFs, similar to a “short” position that attempts to profit from a decline in the price of a given investment. For example, an inverse “short” S&P 500 ETF generates returns that are the opposite of the S&P 500. Thus,
- if the S&P 500 is UP 10% in a given time period, the inverse “short” ETF should be DOWN around 10%.
- if the S&P 500 is DOWN 10% in a given time period, the inverse “short” ETF should be UP around 10%.
Inverse ETFs are one of the few and, in our opinion, BEST ways to try to profit from a FALL in the price of a given investment.
Levered ETFs are ETFs that use various derivatives like futures and swaps to generate returns that are typically two or three times that of traditional ETFs. For example, a “double-long” S&P 500 ETF generates returns that are two times the returns of the S&P 500. Thus, if:
- the S&P 500 is UP 10% in a given time period, the double-long ETF should be UP around 20%.
- the S&P 500 is DOWN 10% in a given time period, the double-long ETF should be DOWN around 20%.
There are also levered inverse “short” ETFs that generate returns two or three times in the opposite direction of a given investment. For example, a double inverse “short” S&P 500 ETF should be UP around 20% if the S&P 500 falls 10% and vice versa. Levered ETFs can be very profitable if you have high conviction and are correct about the price direction of a given investment, but they can be very unprofitable if you are incorrect...so they should be used cautiously.