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Consider Trading ETFs

E xchange-traded funds (ETFs) are becoming an increasingly important investment vehicle and alternative to mutual funds. They’re an affordable and convenient way to diversify investments in your portfolio, but be sure to consider the many types of ETFs and their pros and cons to find an ETF that helps you meet your financial goals.

Key Takeaways:

  • Exchange-traded funds (ETFs) bundle stocks, bonds, options, and other investment vehicles into one tradable investment option.
  • The large variety of ETF types spans industries, geographical regions, and investment options.
  • Trading ETFs involves reviewing an ETF’s size, expense ratio, exchange location, and subsequent taxing as well as how it’s managed and the fees involved.
  • Advantages of trading ETFs include instant diversification and saving money on buying and brokerage fees, while disadvantages include fees related to actively managed ETFs.

What Are Exchange-Traded Funds?

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Exchange-traded funds (ETFs) are made up of various securities, including stocks, commodities, assets, bonds, or a mixture of different investment types that are traded on an exchange. This mixture allows investors to become instantly diversified without having to purchase numerous investments. Their share prices vary throughout the day, providing investors multiple opportunities to buy and sell as prices change. And these investments are traded during the day — just like stock shares are.

ETFs have many characteristics for investors to weigh, such as:

  • They can be made up of domestic or international underlying investments.
  • They can be passively managed, which means the components are automatically chosen and match an index or part of a market, or they can be actively managed where an individual or team of fund managers determines trades to outperform an index or market.
  • Most ETFs are set up as open-ended funds, which do not limit the number of investors.

ETFs are an excellent match for beginning investors looking for a broad range of opportunities with low costs and low minimum investment.

Types of ETFs

With the large variety of bundling options, there are many different types of ETFs to choose from, including:

  • Stock ETFs: This type of ETF tracks stocks in an industry or an entire index. Stock ETFs provide diversification in a simple, low-cost, and tax-efficient tool that’s easy to trade.
  • Bond ETFs: Government bonds, corporate bonds, state bonds, or municipal bonds may comprise bond ETFs, and assets often change as bonds mature. Their risks include a rise in interest rates, which decreases a bond ETF’s value.
  • Industry ETFs: These ETFs are for a particular industry, such as banking, technology, energy, consumer staples, or real estate, and include domestic or global securities.
  • Commodity ETFs: Providing easy access to commodities like oil and gold, commodity ETFs typically go up in value when stocks and bonds decrease in value.
  • Currency ETFs: These are typically passively managed and invested in a single or multiple foreign currencies to speculate, diversify, or hedge against currency value risks. Currency ETF values are affected by interest rates, global economic conditions, and political stability.
  • International ETFs: Focusing on international markets or a country-specific benchmark index, international ETFs may specialize in emerging or frontier markets in developing countries. Investors can use this vehicle to take advantage of strong global growth but may encounter higher expense ratios investing abroad.
  • Inverse ETFs: Also known as a ‘short ETF’ or ‘bear ETF’, an inverse ETF is specifically designed to do the opposite of the index or benchmark it’s tracking, thus profiting from a decline in the index’s or benchmark’s value. It’s similar to shorting a stock, which is selling before the value of an underlying benchmark and then buying it at a lower price.

How To Buy and Sell ETFs

Here’s what you need to know about trading ETFs:

1. Open a Brokerage Account

ETFs trade through online brokers and traditional broker-dealers, just like regular stocks. Find a brokerage firm you trust, and open an account to begin researching opportunities with an adviser and purchasing an ETF that works for your portfolio. Consider brokerage fees, the trading platform, which markets are available, the ease in opening an account, and the security of trades to help you find the brokerage that’s best for you.

2. Review the Size and Expense Ratio of Various ETFs

On your own or with an adviser, research various countries and sectors where investors believe the market plans to go up. Then, explore both large and small ETFs to see the potential. Larger ETFs are more liquid, which means they are more heavily traded by investors. ETFs with over $100 million in assets under management (AUM) are usually more liquid. Small ETFs may cost more than investing in the individual stocks within them.

Then, consider expense ratios, which show the annual fee of the ETF. Expense ratios under 0.1% are very good.

3. Consider the ETF Type and Exchange

Review the ETF’s domicile — the country of origin — and its trading currency to understand taxes or additional fees you may face. ETFs may be traded on several exchanges, so it’s best to choose the exchange with the lowest commission. And be mindful of currency conversion, but it’s usually best to buy an ETF that uses the same currency as the brokerage.

4. Choose Between Passively or Actively Managed Funds

Determine whether the ETF is passively or actively managed, and weigh the extra cost versus the potential returns when considering an ETF.

Passively managed ETFs have:

  • Lower overhead because they match an index or part of a market.
  • Automatically chosen components.
  • Good diversification.
  • Low turnover.
  • Low management fees.

Some ETFs that are passively managed could contain all stocks in an index. However, ETFs don’t always track an index and have passive management.

On the other hand, actively managed ETFs have:

  • An active manager who buys undervalued securities and sells overvalued securities, seeking to take advantage of market inefficiencies.
  • Potentially higher returns since they’re actively researched and traded to outperform an index or market.
  • Higher expenses.

Actively managed ETFs can outperform indexes and markets, but investors need to balance the higher returns with the higher fees as well as be aware of their short-term and long-term strategies.

5. Purchase an ETF That Helps Your Financial Goals

There are many types of orders you can place when purchasing your ETF to better manage your trading activities, including:

  • Market orders are the most common and are executed at the current best price and take effect right away.
  • Investors may also choose limit orders where they set a buy price and a length of the request.
  • Stop orders and stop-limit orders secure profits and minimize losses by automatically executing trades or placing them on hold.

6. Set a Stop-Loss Price for Short-Term Opportunities

Short-term buyers should consider a stop-loss price, a threshold where they would cut their losses. They should also set a target price where they can sell for a profit.

7. Monitor the ETF’s Performance

Brokers suggest that long-term buyers monitor investments monthly to yearly. Value is easy to look up using ticker symbols.

Advantages and Disadvantages

ETFs, like all investments, have positive and negative traits to consider before making an investment decision.

Advantages

Consider these positives to trading ETFs:

  • Diversification: Investors have the ability to bundle various investments into a diversified portfolio, making ETFs an ideal asset for new and veteran investors alike.
  • Hedging risk: Investors can focus on certain industries while limiting risk through an investment vehicle that is already diversified.
  • Lower fees and expenses: Investors only have to initiate one transaction to purchase an ETF, which saves broker fees. Also, ETFs generally have lower expenses for operating and managing the fund because they track an index. Plus, ETF investors have access to many stocks across industries and have low expense ratios and commissions.
  • Cost-effective: By bundling different types of securities instead of purchasing individual ones, investors save money on upfront purchasing costs. ETFs also offer more cost savings and liquidity than other funds, holding hundreds or even thousands of different stocks in either similar or diverse industries.

Disadvantages

Here are some disadvantages related to various ETFs:

  • Potential for higher fees: Actively managed ETFs have higher fees, so choosing passively managed ETFs can help you lower those costs.
  • Possibility for limited diversification: Because some ETFs focus on one industry or sector, these investment options have limited diversification than their multi-industry counterparts. And with this limited diversification, dividends are lower. However, they’re often still more cost-effective than buying each investment individually.
  • Transaction delays: Certain ETFs have less liquidity than other investment options, which may lead to slower transactions. Monitoring your ETF and consulting with your adviser can help you stay on top of necessary order transactions.
  • Less control over volatility: ETFs that follow indexes closely will go up or down with those indexes regardless of how they are managed.

Dividends are lower since ETFs track the broader market and have a lower overall dividend yield. ETFs in some sectors or foreign stocks may be limited to large-cap or narrow index of stocks. Investors would have a lack of options and access to potential opportunities to invest in smaller companies.

Investing in ETFs is another great option for a variety of investors, and learning all you can about these potentially high-earning security bundles can help you make smarter decisions for your portfolio. Consider ETFs when formulating your investment plan.

Author:Ben Sturgill

Ben leads two services at RagingBull. IPO Payday can help you pinpoint, position, and profit from IPOs. In Daily Profit Machine Ben guides day and swing traders to profit by trading the SPY Index. Ben hosts the RagingBull.com podcast where he shares thoughts on wealth and success with traders, businesspeople, entrepreneurs, and experts to uncover and share some of the wisdom needed to live a successful life.

How Does an IPO Work?

W hen a private company wants to begin selling shares of its stock to the public, it makes an initial public offering (IPO). While the primary purpose of an IPO is to raise significant capital from the investing public, this step also raises the profile of the firm and creates further opportunities for expansion and growth. Explore how this process works behind the scenes.

What Is an IPO?

How does an IPO work? An initial public offering allows the public to purchase shares in a company’s profits to raise capital for growth, expansion, and other endeavors. As the company grows, shareholders benefit from the increase in the value of their stock and other advantages, such as voting rights, while its early private investors can take advantage of benefits like premiums and preferred shares.

A firm issuing an IPO must meet all regulations of the federal Securities and Exchange Commission. This ensures that the company provides transparency to the public.

Before issuing an IPO, a company’s investors are limited to its founders and their personal networks, angel investors, and venture capitalists. After an IPO, the firm can access public capital as well as favorable terms when borrowing funds to expand the business.

To understand how an IPO works, review the steps to forming an IPO. These include:

  1. Starting the IPO process: This occurs when a firm hits a value of at least $1 billion or displays significant growth potential and the founders determine that an IPO is the best way to expand.
  2. Finding an underwriter: An investment firm or bank will facilitate the IPO process, purchasing the initial release and reselling to institutional investors and other stakeholders.
  3. Creating IPO documentation: These documents must be reviewed and approved by the Securities and Exchange Commission before the IPO moves forward.
  4. Pricing and marketing the IPO: The right share price will drive both profit and demand, informed by the process of advertising the new release. The underwriting team does not finalize the price until the day before the IPO.
  5. Releasing the IPO: The majority of shares go to brokerage firms and other institutional investors.

Starting the IPO Process

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First, when the company’s founders make a decision to go public, they must initiate the IPO process. Usually this happens when the firm has a value of $1 billion or higher, but companies with a lower value can be IPO-eligible as long as they can meet SEC requirements and display strong potential for growth and profit.

Sometimes, the firm will make a public statement about its upcoming IPO. They may also conduct a private search for an underwriting institution to value its shares and issue the IPO.

Before releasing an IPO, a company is completely owned by its founders and original investors, which may include venture capitalists, angel investors, or private shareholders. After the release, the shareholders own the company and hold sway over its direction with voting rights. However, a company does not have to sell its entire equity in the form of stocks. Often, they will decide to offer only a percentage of shares to the public and keep the remaining shares under private ownership.

Finding an Underwriter

The company offering an IPO must hire a professional valuation firm to conduct due diligence in pricing its IPO shares. Each underwriting company offers a proposal that details its services and makes recommendations about the types of shares the firm should issue, the number of shares, the offering price, and the proposed schedule for the IPO.

When the company selects an underwriter, they will enter a formal agreement that details the complete terms of the IPO. They also assemble the underwriting team, which consists of the underwriters and the executives from the company as well as SEC experts, accountants, and attorneys.

Creating IPO Documentation

The official SEC paperwork to apply for an IPO includes the S-1 registration statement. This document includes the company’s private filing information and IPO prospectus. As the committee gets closer to the IPO date, they will frequently revise this document to reflect the final offering.

The S-1 includes the company’s business plan, details about the ownership of its private shares, possible liabilities such as legal issues, biographies of each founder and member of the executive team, and comprehensive financial information including the results of an independent audit.

The SEC will review the IPO application and ensure that the company meets federal regulations. After approving the IPO, the SEC requires the company to regularly provide public disclosure of its financial standing, hold shareholder meetings, and follow other federal guidelines.

Pricing the IPO

The committee will also develop marketing materials to advertise the upcoming IPO. The marketing process will inform the final IPO offering price, as it allows the committee to gauge demand for the new public shares.

During this step, the company must consider the transition for its private shareholders. Often, their holdings will convert to public shares at the new, higher value. However, many private investors decide to cash in their shares and realize their returns when the company goes public.

As the company prepares to go public, the underwriting firm presents the prospectus to potential investors from all over the world. While these can be in-person presentations, as suggested by the common moniker ‘roadshow,’ many such events actually occur virtually.

When an investor is impressed by the IPO presentation, they can obtain an allocation of shares at the IPO price before the stock goes public. Usually, this process targets large institutional investors. Ideally, the roadshow will build buzz for the release of the new shares. The amount of interest generated during the run-up to the IPO will also inform the eventual share price.

Releasing the IPO

The underwriter and the company will work together to set a final stock price the day before the IPO drops. This is often quite different from the target price the team set at the beginning of the process. The right stock price is critical; ideally, it will be high enough to drive demand and create a steady value increase, but not so high that demand will flag, which can cause the price to drop.

If you’re interested in an IPO as an individual investor, most experts recommend waiting a few weeks until the stock price settles. Institutional investors such as banks and brokers buy about 80% of the IPO shares, with the rest allocated to the firm and underwriter’s clients and associates.

Some brokers do offer IPO access to high-volume individual investors who do not have a history of flipping stocks (a practice that can artificially drive up the IPO price). If you think you may qualify, talk to your broker directly to learn more about the process. When purchasing an IPO, you should conduct the same due diligence as you would for other types of investments.

Advantages of Forming an IPO

Of course, the primary benefit of forming an IPO is the opportunity to access capital from the entire scope of public investors. Other advantages for the firm that decides to go public include:

  • Easier company valuation because of publicly listed share prices, which helps facilitate potential mergers and acquisitions.
  • Better terms for financing because of the transparent, publicly available information about the firm’s financial health.
  • Access to lower debt and equity costs.
  • Enhanced public image and publicity, which can increase the company’s sales and attract high-quality employees and managers.
  • The ability to offer stock equity as an employee benefit.
  • The ability to issue more stock shares to raise additional capital in the future without having to go through the SEC approval process for an IPO again.

Disadvantages of Forming an IPO

While issuing an IPO has many benefits, it’s not the right choice for every company. Some of the potential disadvantages of going public include:

  • The cost of issuing an IPO and managing a public company, which far exceed the costs of running a private company.
  • The requirement to publicly disclose the company’s complete financial information, which for some firms may result in the release of trade secrets to competitors.
  • The risk that the IPO will be unsuccessful.
  • The time and money required to fulfill quarterly SEC reporting requirements for public firms.
  • Potential regulatory and legal issues, such as shareholder lawsuits.
  • Potential loss of control to a new group of shareholders with voting rights and/or the new board of directors.
  • Changes in stock value can distract management from the firm’s core business objectives.

O nce the dust settles from the initial IPO release, the underwriting firm will issue a report about its performance. After six months (180 days), investors who owned shares in the company before the IPO can cash out and sell their percentages for a healthy profit. Understanding the question of how does an IPO work provides stock market insight that could help inform your trading activities.

Author:Ben Sturgill

Ben leads two services at RagingBull. IPO Payday can help you pinpoint, position, and profit from IPOs. In Daily Profit Machine Ben guides day and swing traders to profit by trading the SPY Index. Ben hosts the RagingBull.com podcast where he shares thoughts on wealth and success with traders, businesspeople, entrepreneurs, and experts to uncover and share some of the wisdom needed to live a successful life.

Investing in an S&P Equal Weight ETF

T he S&P 500 is known for being top-heavy. Big-name companies like Amazon, Apple, and Facebook account for a huge chunk of the total weight of the index.

While many investors consider the S&P 500 to be at the top of the list of large-cap index funds you can buy, you might balk at the fact that the index is incredibly concentrated (especially in terms of tech stocks). You take a risk by buying into indexes that have a high concentration of high-priced stocks like this. However, equal weight ETFs help avoid this problem while still offering exposure to the stocks included in the S&P 500.

Key Takeaways:

  • The S&P 500 Equal Weight Index was created as a way to give investors an equal-weight method of investing in companies and sectors included in the traditional market capitalization-weighted S&P 500 index.
  • Equal weight ETFs give every included stock equal weight, no matter how big or small a given company is. This differs from market value-weighted funds, which can get overwhelmed by one or two stocks that perform well.
  • Equal weight ETFs rebalance on a regular basis to retain equal division among all their components.
  • Equal weighted ETFs offer an intriguing investment opportunity for long-term investors, thanks to their inherent diversification.

What Is the S&P Equal Weight ETF?

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The S&P 500 Equal Weight Index, or EWI, was created in January 2003 to give investors an equal-weight option to the popular S&P 500 Index. The same stocks make up both indexes. However, different weighting structures mean the EWI version has different properties and offers different benefits to investors.

The S&P 500 is a stock market index. It measures the performance of around 500 United States-based companies. The index includes companies in 11 sectors in order to give investors a snapshot of the U.S. stock market and the broader economy.

S&P 500 Market Weight ETFs vs. S&P 500 Equal Weight ETFs

To better understand what an S&P Equal Weight ETF really does, let’s explore both market weight ETFs and equal weight ETFs.

Imagine the S&P 500 as a pie (or pie chart). A market weight ETF breaks that S&P 500 pie into slices determined by the market cap. On the other hand, an equal weight ETF means that all of the slices are the same size, no matter how big or small a sector or company is.

S&P 500 Market Weight ETFs

Like many other stock market indexes, the S&P 500 is an index weighted by market capitalization. You can determine the market capitalization of each stock by multiplying the share price of that stock by the number of outstanding shares. Companies that have the greatest values due to the largest market capitalizations will also have the highest weight in that index.

Many companies comprise the S&P 500 index. However, the sector weight of a market value-weighted index, or MWI, is calculated as the sum of individual weights of companies that make up a given sector. The weight of any company in the index equals that company’s market cap divided by the total market cap of every company in that index.

S&P 500 Equal Weight ETFs

Once you know what a market-weighted index is, you’ll see that an equal-weighted index is pretty much what it sounds like. Every stock in that index has an equal weight. That weight is the same no matter how small or big a given company is. In other words, an industry giant like Apple ends up having the exact same weight that the smallest company in the S&P 500 has.

When it comes to equal weight indexes, sector weight is truly a direct function of the number of companies that exist in a sector. If a sector has 50 stocks, for instance, the weight of the sector, in theory, will be 10% (or 50 / 500 x 100).

Key Differences to Consider When Investing

A few key differences between market and equal weight ETFs exist, including:

  • Balancing and adjusting needs: While both the normal market weight ETFs and the equal weight ETFs need to be adjusted periodically, the equal weight ETFs must also be rebalanced. You do not need to rebalance market-weighted ETFs.
  • Sector exposures: Because the S&P 500 and S&P 500 EWI have different weighting schemes, this will create different sector exposures.
  • Volatility: Generally, volatility is higher on the S&P 500 EWI than on the S&P 500. This happens because small-cap stocks tend to be more volatile than bigger companies. As the S&P 500 EWI tilts more toward small-cap stocks than the S&P 500, it creates higher volatility on the EWI.

You can trade ETFs that represent both the equal weight index and the traditional index. However, even if two kinds of ETFs have the same basket of companies, that does not mean they will perform similarly at all.

Advantages and Disadvantages of Equal Weight ETFs

If you’re an index investor, owning one big individual stock comes with considerable risk. The point of indexes is that they get you diversification. However, indexes weighted by market caps (like the S&P 500) can mean that a couple of stocks that make big gains can turn into a disproportionate share of an investor’s holdings. Even if those stocks are generally great, it creates risks for the investor because the inherent benefit of diversification is reduced.

You can mitigate that problem by investing in index ETFs that are equally weighted. Advantages of equal weight ETFs include:

  • Better risk-adjusted performance: S&P equal weight ETFs may perform better when adjusted for risk than their traditional counterparts that are weighted by market cap.
  • Increased diversification: Instead of being concentrated into the largest companies in an index, equal weight ETFs are much more diversified.
  • Increased protections: Equal weight ETFs offer investors more protections in case a large sector goes on a downturn. Because there’s equal weighting, small sectors that are underperforming can offset losses more than they could with a market weight ETF. You’ll thus reduce your exposure to steep declines.
  • Long-term gains: Equal weight ETFs go against momentum because they’re constantly rebalancing. While you can ride momentum up with market cap weighted indexes and make significant short-term gains, you have no way of getting those stocks out when they take a downturn — and you end up going along with that momentum down again. That why equal weight ETFs tend to be a good choice for long-term investors.
  • Natural value-approach: If you’re an investor that looks for a value-approach, equal weight ETFs naturally provide that.
  • Regular rebalancing: Because equal weight ETFs have an equal amount of every stock in a given index or sector, they rebalance on a regular basis (typically each quarter). They do this by selling excess gain of winning stocks and purchasing enough of the losing stocks to maintain the equal weighting of the portfolio.

Equal weight ETFs also have a few disadvantages, including:

  • High turnover: Because equal weight ETFs tend to have a higher turnover than market cap counterparts, you’ll have to contend with higher expense ratios and higher capital gains taxes.
  • High volatility: Again, equal weight ETFs are more volatile than market weight ETFs. That makes them more apt to fall sharply during a recession.
  • Potential for sector underperformance: Sectors that have high catastrophic loss rates (such as information technology) can be more likely to underperform in funds with equal weighting.

Finding an S&P Equal Weight ETF to Invest In

You’ll find different ways to invest in equal weight ETFs that focus on various industries. Here are a few to check out when you’re ready to start investing. Keep in mind that these are just options to consider, and we are not making any recommendations.

  • Invesco S&P 500 Equal Weight ETF (RSP): This ETF offers an intriguing opportunity for risk-averse investors. By targeting even allocation in each of the S&P 500’s stocks, this ETF avoids heavy concentration on any single area of the market and thus provides even more diversification than other investing possibilities. The diversified approach also allows the fund to avoid volatility that can affectfunds benchmarked to an S&P index that’s market weighted.
    • SPDR S&P Bank ETF (KBE): This ETF of approximately $1 billion spreads investments evenly throughout the financial sector. This allows the fund to stay away from relying on bigger Wall Street banks. The ETF instead goes for allocations lower than 2% in all of its 86 components. By ensuring that small, regional stocks included in the fund have the same effect as bigger banks, KBE reduces volatility and adds diversification.
  • SPDR S&P Biotech ETF (XBI): This ETF tracks the S&P Biotechnology Select Industry Index. The Index holds small-, mid-, and large-cap stocks in the biotech sector. It’s a relatively affordable option that finds stability thanks to its huge sum of assets and high daily trading volume.
  • SPDR S&P Aerospace & Defense ETF (XAR): Like tech, the aerospace and defense sector can populate ETFs with a small number of huge stocks. This ETF ensures that the typical industry giants don’t overshadow small stocks.

B y investing in an S&P equal weight ETF, you’ll get more protection if a sector experiences a downturn. This investment strategy can work well for investors with a long-term outlook.

Author:Ben Sturgill

Ben leads two services at RagingBull. IPO Payday can help you pinpoint, position, and profit from IPOs. In Daily Profit Machine Ben guides day and swing traders to profit by trading the SPY Index. Ben hosts the RagingBull.com podcast where he shares thoughts on wealth and success with traders, businesspeople, entrepreneurs, and experts to uncover and share some of the wisdom needed to live a successful life.