Daniel X. Bustamante, Co-Founder and Lead Coach

Exchange-Traded Funds, or ETF’s as they are commonly referred to, are arguably Wall Street’s most popular products to trade. Each year, new ETFs come and go. The volumes that are used on them are just incredible. More recently the addition of Tesla Motors into the S&P 500 (SPY) ETF and the subsequent rally that came on Tesla is an example of this.

What is an ETF?

An ETF is a product traded on the stock exchange and can be made up of different securities and assets. These can range from stocks, currencies, fixed income, and commodities (such as gold). Through an ETF you can participate in international and emerging markets to.

They combine features and potential benefits of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that’s assembled by professional managers.

There are a number of types of ETFs, each with a different investment focus. Following are some of the most common ETFs.

Index ETFs

Index ETFs are designed to mirror the performance of widely followed stock market benchmarks such as the S&P 500, the Dow Jones, Nasdaq or even the Russell 2000.

Active Equity ETFs

Active equity ETFs allow their managers to use their own judgment in selecting investments, rather than rigidly pegging to a benchmark index. while Active ETFs may offer the potential to outperform a market benchmark they may also carry greater risk and higher costs.

Fixed-Income ETFs

Fixed-income ETFs focus on bonds rather than stocks. Major fixed-income ETFs tend to be actively managed. They have relatively low turnover and generally stable portfolios

The structure of ETFs

Originally, ETFs were organized as unit investment trusts (UITs). In a UIT, an investment company buys a fixed portfolio of securities and then sells shares of that portfolio to investors. This type of structure results in dividends being held in an interest-bearing account. They are then deposited into the ETF, generally once each quarter. The delay in investing dividends can have a slightly negative effect on the total return of the ETF. This is because the dividends are held as cash instead of being invested.

There are now ETFs that are structured as open-end funds. This arrangement follows the typical mutual fund structure in that new shares are continually offered and redeemed by the investment company. An open-end structure allows dividends to be reinvested immediately

Advantages and Disadvantages of ETFs

As with anything, there are advantages and disadvantages. The advantages are:

  • Potential tax efficiency
  • Low expense ratios
  • Trades throughout the day on an exchange
  • No minimum investment dollar amount (may not buy fractional shares)
  • Can be sold short and bought on margin

The disadvantages are:

  • Capital gains occasionally distributed
  • Flexibility may encourage frequent trading, potentially negating the tax-efficient edge

Evaluating ETFs

Tax efficiency: ETFs may be more tax-efficient than some traditional mutual funds. A mutual fund manager may trade stocks to satisfy investor redemptions or to pursue the fund’s objectives. Selling shares may create taxable gains for the fund’s shareholders. Because ETFs are like stocks, redemptions aren’t an issue. In addition, managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.

Low expenses: ETFs that are passively managed (managers usually only trade shares to mirror underlying benchmarks) may have lower annual expenses than actively managed funds.

Flexible trading: Like stocks, ETFs are sold at real-time prices and trade throughout the day. Mutual funds, on the other hand, do not have this flexibility: Their pricing is based on end-of-day trading prices.

Can be sold short and bought on margin: Because ETFs trade like stocks, investors can use them in certain investment strategies, such as selling short and buying on margin.

No minimum investment: Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.

Diversification: An ETF may be a good way to add diversification to your portfolio. Buying shares of a technology sector ETF, for example, could potentially be less risky than purchasing shares of one technology stock — an ETF may own shares of many different technology companies.
their underlying benchmarks. Additionally, government bond ETFs are subject to federal income tax.

You should carefully consider the risks of different ETFs. Many sector ETFs, for instance, will tend to be more volatile than an ETF that tracks the broader market. Check with a financial professional to be sure that you understand the risks and have the most up-to-date information before investing in an ETF.

Trading ETFS

Trading ETFs, for me, is a personal favorite, especially with options. We start of teaching how to trade ETFs in our FoundationalAbilities course. hen I trade ETFs, I like to primarily stick with the following:

  • SPY
  • QQQ
  • VXX
  • IWM
  • TLT

Now there are quite a lot more to use and trade but when I use them I use them from a trading perspective. Those above generally move extremely well and they allow me to get into the underlying options and trade with them as a group. I recall earlier this year being short TLT when the Coronavirus hit (take a look at the March chart of that) and it had turned out to do extremely well.

One of the other trading advantages of ETFs are they allow you to focus on sectors as a whole v. individual stocks. For most retail traders focusing on less can usually be a fix and allows them to become a specialist. While we all want to find high-flying stocks looking at those names above can potentially lead to large dollar priced moves which should not be over-looked.

In fact, my most recent trade plan has me focusing on QQQ, SPY and IWM with a few additional equities. I get access to the broad indices with those above and it lets me trade less and look for better moves (aka, being picky).

I hope that this article helps!

Daniel X. Bustamante