What are ETFs?
ETFs (exchange traded funds) are marketable securities that monitor and attempt to mimic the performance of an index. An Exchange traded fund also tracks commodity, index, sector and other assets as well. One of the benefits of the ETFs are that it can be molded and constructed in such a way that it can track the price of an individual commodity and or a combination of multiple securities. It exhibits features similar to a stock and as well as mutual funds in several ways. It’s comparable to a stock in that it’s traded on a stock market, and it’s similar to a mutual fund in that it’s made up of several individual assets (Madhavan 2016). The fundamental difference between an ETF and a mutual fund is that the net asset value of an ETF is not determined at the end of the day like it is in a mutual fund. An ETF can have a variety of benefits and drawbacks which are discussed below.
In terms of operations and management, ETFs are less expensive than index funds. ETFs offer flexibility since they are comparable to stocks and are exchanged on the securities exchange like regular stocks. Specific characteristics associated with stocks, such as purchasing on margin (using borrowed money from the broker), stop and limit orders if authorized by the broker, and selling short of shares (depending on stock exchange limits), are also accessible in the case of ETFs. ETFs are considered to be liquid as they are exchange traded and this acts as an advantage to the investors (Madhavan and Sobczyk 2016). Because ETFs are available for various indexes, track several benchmarks, engage in diverse markets, and monitor specific asset classes which includes large cap industries, small capitalization industries, middle capitalization industries. One has to pay commission fees and maybe extra brokerage costs when you purchase and sell ETFs. This is one of the most significant drawbacks for investors looking to save costs. There is no guarantee that the market price of an ETF will correspond to the market price of its underlying assets. Price volatility is comparable to that of stocks, reducing the factor of diversity. The majority of publicly listed ETFs are now passively managed, leaving investors with little choices for boosting gains or reducing losses through portfolio building. Many ETF providers provide poor customer service. This is particularly worrisome for new investors or elderly persons who are unable to grasp the complexities various investment alternatives and kinds available. There are a variety of ETFs that pay monthly dividends, but the yield given by ETFs is often smaller than the dividend yield of a stock. Investing in ETFs is less hazardous than investing in stocks, but if an individual is ready to take on more risks, higher returns can be obtained by the individual in that case (Israeli, Lee and Sridharan 2017).
When you buy stock in a firm, you get a portion of that company’s ownership. When you buy a stock in a firm, you are purchasing a little chunk of that company, with the proportion of ownership rising with each additional share acquired. Investing in common stocks of firms may be done for a variety of reasons. Some of the rationales based upon which investors tend to choose stocks for the purpose of investment are discussed in detail below:
Benefits of ETFs
The high return associated with stocks is the major reason individuals select them above any other product for investing purposes (Pericoli 2018). Stocks have a bigger potential for growth and have shown to be incredibly successful in the past. Stocks generate significantly better returns than bank savings, gold investments, government bonds, and business bonds. The average stock market return over several decades has been in the double digits, whereas returns from another specified mode of investment have traditionally been less than 10% (Bogle 2017). The level of inflation in a specific economy varies depending on the present situation. The primary reasons of inflation in an economy is rising of household income and rising demand of essential commodities like food, grains and petroleum products. Investing in stocks has an advantage compared to investing in other markets as it has been observed that stocks are a good inflation hedge due to the diversity of stocks available to invest. Investing in consumer-oriented firms’ equities helps safeguard investors’ wealth from being eroded by inflation since the companies are able to pass on the impact of rising prices to their customers, increasing corporate profitability. The stock price, which tends to trend upwards, reflects this growth in profitability. Some investors are primarily motivated by the desire to get capital appreciation by investing in stocks, while others are solely motivated by the need to receive regular income from their assets in order to cover their monthly costs. Dividend-paying corporations are ones that are noted for annually passing on profits to shareholders in the form of dividends, which serve as a source of income for many investors. The majority of corporations are recognized for paying quarterly dividends, while other companies prefer to pay annual dividends. The primary use of the dividend can be in the form of meeting needs of individual during the period of retirement. Thus due to a regular stream of income being an important factor in determining the mode of investment, stocks are preferred by investors. Although, bonds also have a feature of providing regular stream of income, the dividend yield provided by stocks are generally higher than that of the yield provided by bonds (French and Patrick 2015).
Stocks are regarded riskier than bonds because stock returns are more volatile than fixed income securities. Bonds are known to provide consistent income in the form of a coupon that is received on a regular basis. The reason for investors preferring bonds over stocks for regular stream of income is that investments in bond are comparatively less riskier than bonds as the payment structure of the coupon are known and constant over the life of the bonds (Lin et.al, 2018). Because of the uncertainty surrounding the operations of various firms, stock investments may suffer losses. Bondholders, on the other hand, may be able to recover their capital before shareholders in the event of a company’s liquidation or bankruptcy.
Efficient Market Hypothesis is a theory which advocates that there is no way to outperform a market based on a risk adjusted basis regularly, as stock price in a market incorporates all the necessary information that has the potential to inflict changes in the price of a stock. The prices of stock in a market are only sensitive to new information according to this theory. Although this theory has been promoted by various researchers historically, decades of empirical studies related to the potential of this theory for predicting the future stock price movements have provided mixed evidences (Naseer and Bin Tariq 2015). According to this theory there can be three forms of market efficiency, which are explained in detail below:
Drawbacks of ETFs
Weak form efficiency means that any information about price fluctuations, volume, or earnings is unhelpful for predicting future price movement. The weak form denotes that the current price is a reflection of all previous price data. It asserts that fundamental analysis and technical analysis may help investors find cheap and overpriced stocks, and that investors must look at firms’ quarterly earnings to boost their odds of outperforming the market or the benchmark (Hamid et.al 2017). According to the semi-strong version of efficiency, all information about a particular stock is absorbed into its price; hence fundamental research cannot be utilized to predict stock price movement. Fundamental events including earnings releases, annual financial performance reviews, initial public offerings, stock splits, and organizational restructuring have little effect on stock price movements since they are swiftly integrated in the share price under a semi-strong type of effectiveness (?i?an 2015). Strong form market efficiency advocates that all companies’ share prices represent all information in this sort of market efficiency, fundamental and technical studies are ineffective for anticipating price movement. In such a market, it’s difficult to earn significant gains by examining any form of data. All private and public data, including vital non-public data, are compensated for in the market price, according to the strong form of efficiency. This form of market efficiency has been questioned by some analysts and academics since it is rarely feasible (Lekovi? 2018). Although it is always possible to get unusual advantages by leveraging insider information, markets which are financially sound and matured with respect to the investors can also not be considered as strong form efficient, as there remain certain loopholes in every market.
References
Bogle, J.C., 2017. The little book of common sense investing: the only way to guarantee your fair share of stock market returns. John Wiley & Sons.
French, N. and Patrick, M., 2015. The plethora of yields in property investment and finance: a summary. Journal of Property Investment & Finance.
Hamid, K., Suleman, M.T., Ali Shah, S.Z. and Imdad Akash, R.S., 2017. Testing the weak form of efficient market hypothesis: Empirical evidence from Asia-Pacific markets. Available at SSRN 2912908.
Israeli, D., Lee, C.M. and Sridharan, S.A., 2017. Is there a dark side to exchange traded funds? An information perspective. Review of Accounting Studies, 22(3), pp.1048-1083.
Lekovi?, M., 2018. Evidence for and against the validity of efficient market hypothesis. Economic themes, 56(3), pp.369-387.
Lin, F.L., Yang, S.Y., Marsh, T. and Chen, Y.F., 2018. Stock and bond return relations and stock market uncertainty: Evidence from wavelet analysis. International Review of Economics & Finance, 55, pp.285-294.
Madhavan, A. and Sobczyk, A., 2016. Price dynamics and liquidity of exchange-traded funds. Journal of Investment Management, 14(2), pp.1-17.
Madhavan, A.N., 2016. Exchange-traded funds and the new dynamics of investing. Oxford University Press.
Naseer, M. and Bin Tariq, D., 2015. The efficient market hypothesis: A critical review of the literature. The IUP Journal of Financial Risk Management, 12(4), pp.48-63.
Pericoli, M., 2018. Macroeconomics determinants of the correlation between stocks and bonds. Bank of Italy Temi di Discussione (Working Paper) No, 1198.
?i?an, A.G., 2015. The efficient market hypothesis: Review of specialized literature and empirical research. Procedia Economics and Finance, 32, pp.442-449.
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