What Is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a pool or basket of investment securities that can be traded similarly to stocks or bonds. ETFs let you invest in several securities at once, so think of them as the lazy investor's stock market sampler platter!
ETFs can be structured to track anything, they are like chameleons in the investment world. They can mimic the price of anything from a solo commodity to a vast mix of securities. In addition, they're customizable to match specific investment tactics.
Exchange-traded funds vs mutual funds
ETFs offer the advantage of intraday trading similar to stocks, whereas mutual funds are traded once a day at the closing price, determined by the net asset value. Mutual funds have a long history dating back nearly a century, originating with the launch of the first mutual fund in 1924. Conversely, ETFs are relatively recent entrants in the investment landscape, with the inaugural ETF, the SPDR S&P 500 ETF Trust (SPY), debuting in January 1993.
Typically, mutual funds are actively managed, with fund managers responsible for asset allocation decisions. In contrast, ETFs are predominantly passively managed, tracking market or sector indexes. However, the line between the two has blurred, as passive index funds constitute a substantial portion of mutual funds' assets under management. Additionally, there is a growing array of actively managed ETFs accessible to investors.
Types of ETFs:
A diverse array of ETFs exists to serve investors' needs, whether they seek income generation, speculative opportunities, capital appreciation, or risk mitigation within their portfolios. Below is a brief overview of some of the ETF sectors available in today's market.
1-Passive and Active ETFs
Passive ETFs typically adopt buy-and-hold approaches in an attempt to mirror a specific benchmark's performance. On the other hand, Active ETFs rely on the investment strategies of portfolio managers to potentially exceed benchmark returns. While Passive ETFs are often more affordable and offer greater transparency compared to Active ETFs, they do not offer the potential for outperformance, known as alpha.
2- Bond ETFs
Unlike individual bonds, Bond ETFs lack a specific maturity date. Many investors utilize them to acquire consistent income generated by the individual bonds held within the Fund. These ETFs typically encompass various types of bonds, including government, corporate, and state and local bonds. It's common for Bond ETFs to trade either at a premium (higher) or a discount (lower) compared to the actual bond value. Bond ETFs serve as a valuable, lower-risk addition to stock ETFs.
3- Stock ETFs
Stock ETFs, also known as equity ETFs, consist of a portfolio of stocks representing a specific sector such as automotive, technology, or foreign markets. The primary aim of this diversified exposure is to capture the industry's potential growth, incorporating both established high performers and promising new entrants. Unlike stock mutual funds, stock ETFs typically carry lower fees and do not entail direct ownership of individual securities.
4-Leveraged ETFs
A leveraged ETF seeks to generate returns that are multiples (e.g., 2× or 3×) of the returns of its underlying investments. For example, if a commodity index rises by 2%, a 3× leveraged commodity ETF would aim to deliver a 6% return (and if the index falls by 2%, the ETF would incur a 6% loss). These financial instruments utilize debt and derivatives such as options or futures contracts to magnify their returns. Additionally, there are leveraged inverse ETFs that seek multiplied returns in the opposite direction of the underlying assets.
5- Commodity ETFs
Commodity ETFs, true to their name, invest in commodities such as crude oil, gold or wheat. These ETFs play a crucial role in your portfolio diversification, helping to mitigate risks during market downturns. For instance, they can be your savior and act as a protective shield when the stock market experiences a decline.
Selecting shares in a commodity ETF represents a financially sound decision over physically owning the commodity, primarily due to the elimination of expenses associated with procurement, storage, and insurance of commodities.
6- Bitcoin ETFs
Bitcoin ETFs are taking center stage in this article as the latest cryptographic security. As of January 2024, they come in two distinct forms. The spot Bitcoin ETF, a relatively recent addition, received approval from the SEC during that month. These ETFs provide investors with exposure to Bitcoin's price movements within their standard brokerage accounts. This exposure is facilitated by the acquisition and retention of bitcoins as the underlying asset, allowing investors to purchase shares of the fund.
On the other hand, Bitcoin futures ETFs, which gained approval in 2021, offer investors exposure to cryptocurrency without necessitating direct ownership of the coins. Instead, they utilize futures contracts traded on the Chicago Mercantile Exchange to mirror the price fluctuations of Bitcoin futures contracts.
While the SEC maintains a cautious stance regarding the risks associated with cryptocurrencies, the introduction of these ETFs introduces some regulatory safeguards. Furthermore, they significantly simplify participation in the crypto market.
How Spot Bitcoin ETFs Work
Similar to any ETF in financial markets, Bitcoin ETFs track the underlying asset's price, leading to ETF share prices fluctuating alongside Bitcoin's price movements.
Bitcoin ETFs operate by acquiring a specific quantity of bitcoins, securely stored in a digital wallet by a custodian. Typically, these custodians utilize cold storage vaults, safeguarding bitcoins' keys offline and inaccessible via the internet. Subsequently, the ETFs issue shares representing the bitcoins held by the firm, with share pricing reflecting the current spot price of bitcoin. These shares are then available for trading on traditional stock exchanges.
This approach streamlines bitcoin investment for retail investors and traders, allowing them to buy and sell an asset correlated with bitcoin's value without the need to directly possess bitcoin in their wallets. Additionally, it offers investors seeking exposure to bitcoin within retirement accounts a straightforward alternative to holding bitcoin directly. Besides spot Bitcoin ETFs, derivative-based Bitcoin ETFs exist on the market today and each differs by their structure and exposure they offer to bitcoin price changes.
Spot Bitcoin ETF vs. Futures Bitcoin ETF
Top 10 spot Bitcoin ETFs by fee expense
Below is a list of the approved ETFs and their fees, in order from lowest to highest fee:
Advantages and Disadvantages of Bitcoin ETFs
Advantages
Ease of Access
Opting for a Bitcoin ETF offers exposure to the price movements of Bitcoin without the need to delve into Bitcoin functionality, navigate cryptocurrency exchanges, or bear the direct risks associated with owning Bitcoin. For instance, the responsibility of managing Bitcoins in a wallet and the potential loss due to forgotten passwords are eliminated with a Bitcoin ETF and transferred to the managing firm, streamlining the investment process.
Enhanced Market Liquidity
Spot Bitcoin ETFs streamline the process of buying and selling bitcoins by facilitating transactions through well-known and classic brokerage accounts. This method mirrors the familiar process of trading traditional stocks or ETFs, offering a smooth transition for mainstream investors.
Regulatory Assurance
purchasing bitcoins independently might involve uncertainties regarding regulatory oversight, spot Bitcoin ETFs operate under clear, standardized regulations. These regulations ensure transparency and provide essential safeguards to protect investors' interests.
Disadvantages
Management Fees
ETFs typically impose management fees to cover the convenience they offer. Consequently, holding a significant number of shares in a Bitcoin ETF could accumulate substantial management fees over time.
ETF Tracking Accuracy
While ETFs aim to track the price of an underlying asset, their diversified portfolio may include multiple holdings. As a result, a 50% increase in the price of Bitcoin may not be accurately reflected in the value of the exchange-traded fund due to its other investments.
Absence of Bitcoin Ownership
Bitcoin serves as a hedge against various risks associated with central banks, fiat currencies, and equities. Its independence from central banks provides a means to mitigate risks inherent in the traditional financial system, while the privacy afforded by the Bitcoin blockchain offers protection to users and investors. However, a Bitcoin ETF would be subject to government regulation, negating these benefits and eliminating direct ownership of Bitcoin.
Could Spot Bitcoin ETFs Affect the Price of Bitcoin?
A spot Bitcoin ETF may not directly impact Bitcoin's price, but it can indirectly influence it through various channels. Firstly, increased adoption is anticipated as mainstream investors seek exposure to Bitcoin within their brokerage accounts, leading to substantial investment inflows and heightened demand, consequently driving up Bitcoin prices. Secondly, the approval and launch of a spot Bitcoin ETF would serve to validate Bitcoin's legitimacy within the mainstream financial system, instilling greater confidence and potentially pushing prices higher. Additionally, the introduction of a spot Bitcoin ETF could stimulate increased trading activity by hedge funds, day traders, and speculators, resulting in heightened trading volume and volatility. Finally, proponents argue that a spot Bitcoin ETF could reduce the premiums institutional investors typically pay to acquire Bitcoins through trusts and private funds, thereby exerting downward pressure on Bitcoin prices to some extent.
It's essential to acknowledge that every type of ETF comes with inherent risks. The decision to invest should always be guided by an investor's investment objectives and risk tolerance. It's conceivable that neither type of fund may be suitable for your portfolio. Therefore, thorough research is imperative before making any investment decisions.