ETFs are extremely popular among traders and still growing at a tremendous pace today. It is seen as an alternative to its more expensive counterpart, mutual funds. The main reason why ETF has been on the rise is because it has several attractive features that appeal to the retail and institutional traders alike. This chapter will go through them in greater detail. If you are unclear of how mutual fund works, you may click here for our mini-course on mutual funds.
Why Trade ETFs?
1. Low cost
When you are investing long term, small percentage savings per year can compound to huge savings in the long run. Mutual funds incur high cost, such as management fees, load and miscellaneous fees, but ETFs on the other hand cost much less. To better appreciate the variance in cost we can use expense ratio as a gauge. Generally, the lower the expense ratio, the cheaper/lower the cost/expenses. In research conducted, the average expense ratio of ETFs is only 1/6th that of an actively run mutual fund. This is a huge difference! Such an amount when compounded over a period of 10 years can turn out to be quite significant.
ETFs, like mutual funds, offer great diversification. Diversification essentially puts your eggs into different baskets so that if one basket sees downfall, you still have many others you can count on. Furthermore, ETFs offer a huge range of markets and indexes for an investor to choose from. In fact, it covers virtually every asset class and geographical market there is, large cap, small cap, commodities, biotech, country-specific and region specific. Due to the unique ability of ETFs to cover so many asset classes, it makes it very easy for an investor to diversify his/her portfolio by obtaining optimal weightage for each class.
3. Easy to Trade
The great part about ETFs is that they do not trade like a mutual fund. Mutual funds are usually managed by a professional money manager, only priced at the end of the day, and are actively traded on the stock exchange. Alternatively, an ETF can be actively bought or sold just like a stock. They can even be traded intraday, which is why volatile ETFs attract a lot of day traders. This also opens the door for investors to speculate on ETFs, shorting and trading on leverage, just as a stock could be traded.
Given the straightforward nature of ETFs and low barrier to entry, the popularity of ETFs is easy to comprehend. Cost-efficiency, flexibility and risk-adversity are just some of the few reasons why ETFs are such compelling options for new traders. As with all investments, be sure to educate yourself thoroughly on the subject matter before taking the plunge. We will be going into the mechanism of buying and selling ETFs in the following chapters.