What Is an ETF? A Beginner’s Guide to Exchange-Traded Funds

What Is an ETF?

An exchange-traded fund (ETF) is a type of mutual fund whose capital comes from the pooled investments of numerous investors and which uses the money to invest in a variety of financial instruments including stocks, bonds, and commodities in order to create a portfolio, while offering shares for trading on stock markets.

A share of the ETF provides the holder with ownership of the fund portfolio and its revenues proportionally to the number of shares he possesses. An investor will not have to buy a couple dozen of securities but just one share of the ETF in order to gain access to all of them.

The majority of ETFs aim to replicate the performance of a particular index or a strategy, while there are also actively managed ETFs. The very first ETF that emerged in the United States was SPDR S&P 500 ETF Trust (SPY) in 1993.

How ETFs Work

ETFs trade in two markets which are interrelated. On the secondary market (stock exchange), individual investors trade existing ETF shares during the day at prevailing market prices, which may change depending on the supply and demand.

At the same time, there is a creation and redemption process through the participation of certain authorized participants (large financial organizations) that ensure the alignment of the ETF’s price with its net asset value (NAV). Authorized participants have the ability to issue new ETF shares by transferring a specific basket of securities (or cash) into the fund in exchange for blocks of shares or to redeem shares and receive the underlying assets.

The number of shares of an ETF can vary depending on the demand due to the possibility of issuing/redemption of shares. It should be noted that ETFs usually disclose their portfolios daily.

How Do ETFs Work?

The money of the investors is pooled in ETFs, which is invested based on a stated objective. Some ETFs are designed to track a certain index by trying to replicate its performance less fees and expenses. Other ETFs are actively managed, which means that securities within the ETF will be selected or modified by investment experts according to the ETF strategy.

Units of the ETFs are traded on the stock market just like shares, and their prices can fluctuate during the trading period due to trades among buyers and sellers. The price of the ETF might not equal the Net Asset Value of the portfolio.

Most likely, investors will buy and sell the units of ETF through their brokerage account, and the price received will depend on market factors.

What Are the Main Types of ETFs?

Stock ETFs

These types of ETFs include stocks issued by various companies. There are those that track broad indexes while there are others that have exposure to various sectors of the economy. They give diversified exposure to the market but a more narrowly defined type of stock ETF may have significant sector or stock specific risks.

Bond ETFs

Bond ETFs contain various fixed income securities like government and corporate bonds. These ETFs can offer exposure to interest income and bond markets; however, the price can be affected by the level of interest rates and credit quality.

Commodity ETFs

Commodity exchange-traded products offer exposure to assets such as gold and others. These exchange-traded products come in various types and while there are those that are physically backed there are those that are not.

International and Sector ETFs

These ETFs give exposure to other countries’ stock markets and those in other sectors like technology or healthcare. These products give an investor an opportunity to target various investment opportunities.

What Are the Benefits of ETFs?

Diversification

An ETF provides a chance to invest in several financial assets through one purchase. It may help to lessen the effect of underperformance of one particular asset, but it will not save the investor from market risk.

Trading Possibilities

Unlike the usual mutual funds that are priced once a day, ETFs are exchange-traded and, therefore, can be bought and sold throughout trading hours at the current market rate.

Possibility to Invest at Lower Costs

Most of the index-based ETFs are inexpensive due to the relatively low cost of management. However, it does not mean that all of the ETFs are cheap.

Accessibility

ETFs give the opportunity to get access to various markets and asset classes through one instrument. The size of the minimum initial investment depends on the price of one unit of ETF and market regulations.

What Are the Risks of Investing in ETFs?

ETFS do not provide investors with any guarantees. In case the underlying assets become less valuable, the ETF may decrease in value as well, resulting in losses of investors’ capital.

There is also a group of ETFS that have other risks associated with them. For instance, sector ETFs may be exposed to only a few sectors, interest rate risk for bond ETFs and currency or political risk for international ETFs.

Finally, investors have to take into account issues related to liquidity and valuation. It is possible that an ETF will trade above or below the net asset value of the assets in the portfolio, as well as a large bid-ask spread.

Another risky type of ETF is the one which is leveraged or inverse. The goal of such ETF may be related to daily return.

How to Evaluate an ETF Before Investing

When buying an ETF, consider its investment objective, the securities included in its portfolio, expenses ratio, past performance, and risks. Determine if the ETF is based on a wide index or has a narrow focus.

Investigate the ETF itself through the documentation that is available and know how the ETF realizes its investment objective. Evaluate the cost, trading volume, and possible premium/discount to net asset value against other similar funds.

For Indian investors, the SEBI provides education on exchange traded funds, and the National Stock Exchange of India provides ETF information and trading details.

Conclusion

An ETF is an investment mechanism that enables investors to gain exposure to a basket of assets using units that trade on the exchanges. The benefits associated with an ETF could be diversity, liquidity, and market access, but the level of risks will depend on its composition.

Investors need to know what the ETF holds, its cost, and how well it suits their financial goals before investing in it.