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Investing in ETFs is putting your money into a mutual fund that tracks the price of one asset, such as commodities, stocks or precious metals. The difference of ETFs compared to standard funds is that ETFs are funds that participate in exchange trading.
Investing in ETFs – what does it involve?
Investing in ETFs on an exchange is a good option, as you usually have to pay a low commission. In addition, transactions are made in USD, so foreign exchange costs go away. One of the advantages of ETFs on an exchange is that they are handled in the language. You can also easily settle your taxes.
Investing in ETFs on the exchange is investing for beginners. It’s also a good choice for investors with little capital. For experienced investors, the small palette of ETF choices may not be enough. In addition, the stock market is the right place for people who are thinking about passive and long-term investing and do not have major requirements for the shape of their investment portfolio.
What are ETFs?
What is an ETF? ETFs (Exchange Traded Fund) are one of the easier and less risky and effective ways to invest in the stock market. ETFs are a well-known and popular type of investment fund that largely shows the state of one selected stock market.
How does an ETF mutual fund work?
As already mentioned, an ETF is a type of fund that almost mirrors the state of one of the selected stock exchanges. It works in such a way that when, for example, the DAX index falls, the value of the units of the Lyxor DAX ETF also falls, and vice versa – if the DAX rises, the DAX ETF also rises.
There are several ETFs available on the Polish stock market, but you don’t have to limit yourself to the WSE alone. All you have to do is set up a brokerage account or an account on an investment platform (international) and with this you can access several thousand ETFs (read also: Trading platform). For example, more than 2,000 types of funds are listed on the American Stock Exchange. You can find ETFs for almost anything, such as gold, silver, emerging markets, technology companies, those that produce organic vegetables or those that own casinos.
ETFs function in a similar way to mutual funds of SIFs and FIZs, and these are as follows:
- ETFs are created indefinitely, but can be terminated in certain cases,
- are subject to national and EU regulations,
- there is an annual fee for managing ETFs,
- ETF units are issued by a fund that is created by an Investment Fund Company.
Investing in oil ETFs
Investing in ETFs is not just about stocks. Money can also be invested in commodities and heavy metals. Investors usually choose this way when the stock market is overvalued.
The subject of ETFs of this type are futures contracts and companies that are involved in the production and processing of various deposits. Oil ETFs are not listed on the WSE, but can be purchased from brokerage houses (read also: Online investment platform for beginners). The most popular of these is the USO fund, which is based on the price of monthly futures contracts. It is listed on the world’s largest commodity exchange – the New York Stock Exchange (NYMEX).
It should be remembered that oil ETFs are traded in US dollars. For this reason, investors should additionally track the USD against other currencies.ETFs for silver and ETFs for gold – is it worth it?
Investing in precious metals ETFs is also quite popular. This type of fund allows you to invest in bullion bypassing the physical purchase of bars. The value of such an ETF decreases or increases with the volatility of the precious metal. ETFs are based on the price of the metal, so you make money on its price movements. It is also worth noting that profits can be made on them only in case of increases.
Where to start investing in ETFs?
Of course, in any case, investing in the stock market, regardless of the chosen asset, should start with acquiring a lot of theoretical knowledge (read also: How to start investing in the stock market). Then you can use it and test yourself by using a stock market simulator. This tool allows you to try your hand at investing in the stock market without incurring any risk of losing real money. This is a good solution especially for beginners.
When starting investing in ETFs, there are several steps to follow:
- Purchase a small number of ETFs from a broker (preferably one that charges a low commission),
- Trade on liquid exchanges where the bid-ask spread is low,
- Adopt a long holding period for the titles,
- Choose funds with a long history – a minimum of 3 years,
- Decide on ETFs with large assets,
- In case of market declines, do not worry about them, and it is even worth buying new ETFs then.
How to build an investment portfolio with ETFs?
Depending on the investor’s decision, there are different ways to build an investment portfolio, such as:
- Using companies in different proportions than they are in the index, or choosing only some of them,
- Accurately replicating the stock market index,
- Self-constructing baskets of companies in such a way as to reflect the behavior of the index.
An investor who builds an investment portfolio can, for example, combine equity, gold and emerging market ETFs.
What makes up the total return on an investment in ETFs?
Investing in ETFs comes with certain fees. In addition to the cost of entry and exit (broker’s commission), as well as the annual fee, the final result is also affected by the discrepancy in the replication of the index, which mimics a specific ETF. Such discrepancies can occur for a variety of reasons, but the main one is that not all ETFs are exactly what they may be considered by their name.
What is the difference between a physical ETF and a synthetic ETF?
ETFs are divided into 3 types, based on how the index is replicated:
- Physical ETFs with full replication – their issuers physically buy any assets that are part of the index. For example, an ETF on the S&P 500 index means that the issuer buys shares of 500 companies and in the proportions in which they are included in the index,
- Physical ETFs with sampling replication – as a rule, they use physical replication, but due to the nature of the assets they include, it can be difficult for the issuer to replicate the index by buying the same assets,
- Synthetic ETFs – they mimic specific indices by using derivatives.
Taxes, or the hidden cost of ETFs
- Investing in ETFs is associated with two types of taxation:
- Tax on profit from trading ETFs – occurs when an investor sells ETFs at a profit,
- Tax on dividends received that are paid by ETFs – occurs when an investor receives such a dividend, but knows that he or she does not necessarily have to receive it. It is enough for the investor to take care of investing in ETFs only accumulating and then avoid the need to account for the dividend yield during the ongoing investment.
It is worth knowing that in the case of receiving dividends from foreign stocks, the tax settlement rules are very simple:
- The broker who pays the dividend to the investor deducts tax from it at source. For U.S. companies, this is 15% – or 30% if the person is not recognizable to the U.S. as an investor from another country that is subject to a double tax treaty. The higher rate unfortunately applies to investors who use brokerage firms from that country,
- After the end of the tax year, the investor is required to pay the amount missing from the capital gains tax himself. In this case it is 4% of the dividend received.
Unfortunately, investing on the stock market in ETFs is more complicated in this regard. Because of the design of ETFs, the calculation of taxes is done on 3 levels:
- Withholding tax on those exchanges or countries where the companies that comprise the ETF are listed. Such tax is paid by the ETF itself,
- Withholding tax of the ETF’s country of residence – this is the tax that is paid by the broker in that country from which the specific ETF fund originates,
- Capital gains tax, which is paid in the country in question.
How much can you earn on the stock market?
Earnings on the stock market vary, this is already known. Making money on ETFs is basically the same as generating profits from investing in mutual funds. They work almost identically. The way to get money with both mutual funds and ETFs depends on the type of investments you have.
Read also: How much can you make in the stock market
What is an ETF? As you know, it is a kind of mutual fund. It can invest in commodities, stocks, bonds, silver, gold or preferred shares. In principle, it all comes down to how the ETF invests the funds.
That is, if an investor owns a stock ETF focusing on high-dividend securities, he or she is counting on earning cash with a combination of capital gains. If an investor holds a bond ETF, he hopes to earn interest income. On the other hand, if an investor owns real estate ETFs, he expects to earn income from rents, etc.
Where to buy ETFs?
When investing in ETFs, an investor has 3 ways to choose:
- Buying ETFs on the stock market with the help of brokerage firms,
- Buying ETFs on foreign markets with the help of brokerage offices. In this case, the number of options available, is much greater, as brokerage offices currently offer more than 600 ETFs on foreign markets. Moreover, the offer is growing all the time,
- Buying ETFs on foreign markets through foreign brokerage firms – this is an ETF investment option that is undervalued in many countries. Many investors are concerned about having an investment account abroad, because in such a situation the investor does not receive a tax form from the broker and must account for capital gains from stock trading and dividends received on his own (read also: Online trading). Many people are also concerned about the safety of assets and the guarantee in case of failure of foreign brokers (read also: Safe investment in the stock market). This is usually unfounded, as the extent of investor protection and the amounts of guarantees that apply to brokers in the UK and the US exceed the level of guarantees that are offered in the country. In addition, the same rules apply to securities as to stocks in the country. They are disconnected from brokers and and individually assigned to the investor. Investing in ETFs with foreign brokers wins in that they have lower commissions when buying stocks and ETFs in foreign markets. The amount of commissions, of course, depends on the specific market in which the investor trades. An investor will pay different commissions when buying ETFs in the US, and others in London or Germany. Therefore, an investor should think beforehand about how he or she wants to transact and how this will affect costs and the return on investment.
How to buy ETFs from the US?
Investing in ETFs in the US has many advantages, including a large selection of funds, high liquidity, lower TER fees, low spreads or the possibility of option strategies. However, it is not so easy. The EU has restricted trading in financial instruments whose issuers do not meet certain conditions. There are several ways to invest in ETFs in the US:
Obtaining the status of a professional investor
In this case, it is enough to have a thick portfolio and demonstrate a history of activity in the brokerage account. Interactive Brokers allows you to become a professional investor if you meet 2 of the following 3 criteria:
- During the last 4 quarters, the investor has conducted transactions of significant size, with a frequency that averaged 10 per quarter,
- The investor has a portfolio of financial instruments, the value of which together with cash exceeds EUR 500,000,
- The investor works or has worked in the financial sector and has a minimum of one year of professional trading experience.
Purchase of ETFs through options
Buying ETFs through options is a method for more experienced players (read also: Playing the stock market). In this case, it is enough that:
- The investor buys CALL options, on the selected ETF – BUY CALl,
- And immediately let the option go to exercise – EXCERCISE CALL.
Buying an ETF at a brokerage that ignores EU requirements
There are bureaus that do not take into account the requirements, set by the European Union. Cyprus-based broker Exante and DIF Broker allow investors from the country to buy ETFs in the US.
How much can you earn on ETFs and is it safe?
There is no clear answer to the question – how much can you earn on an ETF? Just like any other fund, ETFs lose and gain. So the potential profit depends primarily on how long the investment will be and the exact fund in which the investor invests. However, to outline a bit how much you can earn on ETFs, you can cite how much the listed ones have grown by since their inception. The ETFSP500 has earned the most, at 97.2%. It is interesting to note that the S&P index alone has earned only 51.5% in that time.
Read also: How to invest in the stock market
Many people may wonder if this is a safe solution. It is important to remember that ETFs are financial instruments that are traded on the stock market, and like all other investment products, they record not only increases, but also decreases. At any time, the index on which the ETF of the investor’s choice is based may begin to fall, and the ETF will fall along with it. Then the investor will lose his money for a while, or permanently if on an impulse he decides to sell ETFs.
This does not mean, however, that investing in ETFs is not safe and not worth doing. They will work well as a long-term investment, such as for retirement. The design of ETFs is logical and simple, and the costs associated with them are small, and certainly lower than those of classic mutual funds. In addition, since ETFs are traded like stocks, they are traded during each trading session.
This gives the investor plenty of opportunities to close or open an investment at a specific time. Besides, ETFs are a very well-diversified investment product. By buying them, an investor buys many companies at once in the right proportions, which would be much more difficult to do on its own.
Why are ETFs better than traditional funds?
ETFs are mostly index funds, also known as passively managed funds. The advantage of ETFs over traditional funds comes from the fact that they are lighter in terms of annual costs and the level of complexity of their construction and management.
Their simplicity lies in their ability to mimic a benchmark (a benchmark, such as a national or sector index), rather than trying to beat them through asset selection, which is expensive and not always successful. Passive ETFs are cheaper and in most cases perform better than actively managed funds.
ETFs allow investment in broad asset classes
As the number of instruments in a portfolio increases, investment risk decreases. On the one hand, the greater the number of companies in a portfolio, the lower the chance of achieving above-average returns. But on the other hand, a properly diversified portfolio is more predictable. If an investor doesn’t have the time, self-matching companies is a risk of making at least one mistake. Investing in ETFs means diversifying a portfolio without too much risk.
Is it worth investing in ETFs?
ETFs are investment funds that have currently become the most important instrument for passive investing. The advantage of ETFs is broad diversification. With one small investment, many securities can be purchased. Investing in ETFs is characterized by great transparency, since changes in the composition of indices are limited – you know what you are investing your funds in. In addition, the cost of handling ETFs is significantly lower than other financial instruments.
The nature and specificity of ETFs affect savings when characterized by mimicking indices. For this reason, the fund does not involve too many people and does not require specialized programs. Fees for administration and management of the ETF fund can be 0.01% per year. Also, there is no need to pay handling fees. Besides, ETFs are under strict legal protection, as they are intended for the general public. Investing in ETFs is a safe way to invest your money and easy to use for novice investors.
What advantages do ETFs have?
Investing in ETFs has many advantages, including:
- Compared to other mutual funds, ETFs have lower management costs. The fee that is charged for managing the fund already includes exchange fees, asset custody, licensing and administrative costs. Since ETFs are passively managed, the annual fees are several times less than those for FIOs and FIZs,
- Passive management is reflecting the behavior of a specific stock market index and faithfully mimicking its change,
- ETF titles are traded on the stock market in a continuous system,
- Investing in ETFs gives you the opportunity to buy and sell them at any time. They are continuously priced by the market during trading sessions,
- Market makers support the liquidity of ETFs and are contractually obligated to do so.
How to increase returns from investing in ETFs?
As with mutual funds, there are 3 key factors that can help increase returns from investing in ETFs:
- An investor should not invest in ETFs that he or she does not understand. Indeed, there are many strange ETFs around the world. Some of them use very high leverage and short positions on stocks. Others, on the other hand, invest only in countries, are little higher than third world countries, and still others focus on specific industries or sectors. You need to know exactly the composition of the ETFs you own and what purpose you are investing in them for,
- Keeping your ETF costs in line. Of course, this is not a key problem, as investing in ETFs usually generates costs that are very affordable. This is one of the reasons why they are highly coveted by investors – especially those who cannot afford individual account management,
- Focus on the long term – any ETFs should perform like their underlying holdings. This means that if an investor owns a stock fund that is traded on an exchange, he or she may be exposed to relatively large fluctuations in market value in any given year. If an investor cannot handle this, he should not invest in these securities.
Are ETF funds popular?
Although ETFs are growing in popularity year after year, their share of all funds’ assets in the US, for example, was only 10% in 2018. In other countries it will probably be quite a bit less, although interest in ETFs is steadily growing. They are forward-looking funds, and their number is growing steadily, including in other financial markets.
Investing in ETFs is not just about choosing the ETFs themselves or theoretical knowledge of the principles of investment portfolio construction. Practical aspects, such as understanding how certain ETFs are taxed, deciding on a domestic or foreign broker, or selecting ETFs that will best support the investor’s goals, are of great importance for returns. Investing in ETFs, however, is not an expensive endeavor, and the returns can be not inconsiderable.