Updated Mar 07, 2022

What is Exchange-Traded Funds (ETF)?

What is Exchange-Traded Funds (ETF)

 

 

An exchange-traded fund (ETF) is a pooled investment asset that functions similarly to a mutual fund. ETFs frequently track a specific index, sector, commodity, or another asset; but, unlike mutual funds, ETFs can be purchased and sold on a stock exchange in the same manner that traditional stocks can. An ETF can be designed to track anything from the price of a single commodity to a huge and diverse group of commodities. ETFs can be designed to follow essential investment techniques.

 

The SPDR S&P 500 ETF (SPY), which reach the S& P 500 Index, was the first ETF and is still an energetically traded ETF today.

 

An ETF is an exchange-traded fund because it is exchanged on a stock exchange, much like stocks. The worth of an ETF's shares varies at the time of trading day as they are purchased and sold on the market. In contrast, mutual funds are not traded on an exchange and trade only once each day after the markets shut. Additionally, when it comes to comparing to mutual funds, ETFs are most cost-effective and liquid.

 

 

Important Things to remember before investing in ETFs

 

ETFs are not the same as mutual funds. ETFs, in general, combine the qualities of a mutual fund, which can be purchased or redeemed at the end of each trading day at its NAV per share, with a closed-end fund's intraday trading function, in which shares trade at market prices all through the trading day.

Unlike mutual fund shares, ordinary investors can only buy and sell ETF shares on the open market. That is, unlike mutual funds, ETFs do not sell or redeem individual shares directly to ordinary investors. ETF sponsors instead enter into contractual agreements with one or more financial institutions known as "Authorized Participants." Authorized Participants are often large brokerage firms. Only Authorized Participants can purchase and redeem shares directly from the ETF, and only in big aggregations or blocks.

 

Many investors buy and sell ETF shares on the open market at market prices. The market price of an ETF is often greater or less than the fund's NAV per share. This is because the ETF's market price varies all through the trading day due to diverse factors such as the underlying prices of the ETF's assets and request for the ETF, but the ETF's NAV is the value of the ETF's assets minus its liabilities, as measured by the ETF at the end of each business day.

 

 

Types of ETFs

 

Bond ETFs

 

Bond ETFs are utilized to give investors with consistent income. Their wealth distribution is influenced by the performance of the underlying bonds. It may include local and state bonds, corporate bonds, and government bonds, which are known as municipal bonds. Bond ETFs, unlike their underlying products, do not have a maturity date. They typically trade at a premium or discount to the underlying bond price.

 

Stock ETFs

 

Stock (equity) ETFs are a collection of stocks that track a specific industry or sector. A stock ETF, for example, may track automotive or international companies. The goal is to provide diverse exposure to a particular industry that includes both excellent performers and new entrants with development potential. Stock ETFs, as opposed to stock mutual funds, have cheaper costs and do not include actual ownership of securities.

 

Industry/Sector ETFs

 

ETFs that concentrate on a particular industry or sector is known as industry or sector ETFs. An energy sector ETF, for example, will include companies in that industry. The objective behind industry ETFs is to acquire exposure to the upside of a specific industry by following the performance of companies in that field. One example is the technology sector, which has seen a surge in investment in recent years. Because ETFs do not entail direct share ownership, the downside of irregular stock performance is also minimized. Industry ETFs are often used to rotate in and out of sectors during economic cycles.

 

Commodity ETFs

 

Commodity ETFs, as the name suggests, invest in commodities such as crude oil or gold. Commodity ETFs offer several advantages. For starters, they diversify a portfolio, making it easier to hedge against market downturns. Commodity ETFs, for example, can provide a buffer during a stock market downturn. Second, the cost of owning shares in a commodity ETF is less than the cost of owning the commodity itself. This is since the former does not need insurance or storage.

 

Currency ETFs

 

Currency exchange-traded funds (ETFs) are pooled investment vehicles that track the performance of currency pairs, which include both domestic and foreign currencies. Currency ETFs fulfill several functions. They can be utilized to speculate on currency prices depending on political and economic trends in a country. Importers and exporters use them to diversify their portfolios or as a hedge against volatility in FX markets. Some are also employed to protect against the threat of inflation. Bitcoin is even available as an ETF.

 

Inverse ETFs

 

By shorting equities, inverse ETFs aim to profit from stock falls. Shorting a stock means selling it with the expectation of repurchasing it at a cheaper price. To short a stock, an inverse ETF employs derivatives. They are wagers on the falls of the marketplace. When the market condition falls, the worth of an inverse ETF rises respectively. Many inverse ETFs are exchange-traded notes (ETNs) rather than real ETFs, which investors should be aware of. An ETN is a bond that trades like a stock and is backed by a bank or other issuer. Consult with your broker to see if an ETN is a good fit for your portfolio.

 

Leveraged ETF

 

A leveraged ETF is a liquid investment that uses financial derivatives and debt to augment the returns of an underlying index. A leveraged ETF may aim for a 2:1 or 3:1 ratio, whereas a regular exchange-traded fund normally tracks the equities in its underlying index one-to-one.   

 

 

Advantages of ETF

 

• ETFs (Exchange Traded Funds) have various advantages over traditional mutual funds. They're an excellent investment option for first-time stock investors who are concerned about losing money in mutual funds. Why is this so?

 

• ETFs are similar to popular indexes in that they own all of the securities in the index and provide better diversity than mutual funds.

 

• The imitating method (passive fund management) results in fewer transactions than actively managed funds, which buy and sell securities from their portfolio regularly to outperform their benchmark. This churn in actively managed mutual funds increases tax incidence because the funds must pay STT (Assets Transaction Tax) and capital gains tax when purchasing or selling securities in their portfolio. As a result, ETFs are more tax-efficient than other types of mutual funds.

 

• ETFs also have lower expense ratios than actively managed mutual funds, which must employ highly trained fund managers to generate active returns, i.e. returns greater than their benchmark index.

 

• Because ETFs are listed on exchanges and traded like stocks, they provide more convenience and liquidity to investors. Investors can trade ETF funds at real-time prices at any time during market hours, as opposed to actively managed mutual funds, where the NAV is calculated only once a day after the market closes. If you're new to stock investing, ETFs are a great place to start!

 

 

Final words

 

ETFs are utilized by a wide range of investors to diversify their portfolios or get exposure to specific industries. They trade similarly to stocks, but their price movements can also be compared to more wide assets or even entire indexes. They have numerous advantages over other types of managed funds, such as mutual funds.