What is ETF? Pros and Cons
An ETF, or exchange-traded fund, provides a simple and convenient way for investors to access a diversified portfolio of various investments, such as stocks, bonds, and commodities, which can be bought or sold during regular market hours. We have covered What is ETF? Pros and Cons
What Is an Exchange-Traded Fund (ETF)?
An ETF, or exchange-traded fund, provides a simple and convenient way for investors to access a diversified portfolio of various investments, such as stocks, bonds, and commodities, which can be bought or sold during regular market hours.
Many ETFs are designed to track the performance of specific indices, sectors, or international markets. This allows investors to gain exposure to a broad range of companies without having to individually select and purchase stocks or bonds themselves. Not only does this save time, but it can also save money, as ETFs often have lower management fees compared to actively managed investment products.
Passive management is a common feature of ETFs, where the fund follows the performance of an index instead of an investment professional’s strategy. This generally results in lower management fees, making ETFs a cost-effective investment option.
“As of 2021, there were a total of 2632 ETFs in the US..”
“In 2022, the global count of ETFs was 8,754.”
How do ETFs work?
ETFs, or exchange-traded funds, work by pooling money from multiple investors to purchase a diversified portfolio of securities, such as stocks, bonds, or commodities. These securities are chosen to track the performance of a specific index or market sector.
Investors can buy or sell ETFs on an exchange, just like individual stocks, during regular market hours. The price of an ETF is determined by the market demand and supply for that particular fund, so its value can fluctuate throughout the day.
ETFs offer a convenient and cost-effective way for investors to access a diversified portfolio of securities, which can help to achieve long-term investment goals.
What is the difference between an ETF vs. a Mutual fund?
ETFs (exchange-traded funds) and mutual funds are both investment products that provide investors with a diversified portfolio of securities, but there are several key differences between the two:
Trading: ETFs trade on an exchange throughout the day, just like individual stocks. In contrast, mutual funds are bought and sold at the end of the trading day at the fund’s net asset value (NAV).
Cost: ETFs often have lower management fees than mutual funds. This is because ETFs are typically passively managed and follow an index, while many mutual funds are actively managed, which requires more resources and expertise.
Tax efficiency: ETFs are generally more tax-efficient than mutual funds, as they have a unique structure that allows them to avoid the tax implications of selling securities to meet investor redemptions.
Minimum investment: Mutual funds often require a minimum investment to purchase, while ETFs can be bought in any amount, just like individual stocks.
Transparency: ETFs are required to disclose their holdings on a daily basis, providing investors with transparency into the fund’s portfolio. Mutual funds are only required to disclose their holdings on a quarterly basis.
In summary, ETFs and mutual funds both offer investors a diversified portfolio of securities, but ETFs have lower costs, are more tax-efficient, and are traded on an exchange throughout the day, while mutual funds are priced at the end of the trading day and often require a minimum investment.
Who Sets The Price Of An ETF?
The market, rather than any individual or entity, determines the price of an ETF. Typically, the price is based on the underlying value of the investments held by the ETF. For physical ETFs, this calculation is straightforward, as the holdings are known and actively traded on the stock market, allowing for precise pricing down to fractions of a penny.
To maintain price accuracy, “market makers” – large institutional investors or high-frequency traders – often trade ETFs. These market makers look for small discrepancies between the ETF’s price and its underlying assets to make small profits by buying and selling millions of shares.
As investors, we benefit from market makers as they help to ensure there is sufficient liquidity in the ETF market. This liquidity helps to keep the ETF’s price closely aligned with its actual value. However, there are exceptions where an ETF’s price may deviate from its actual value, as demonstrated in the following example.
What are the types of ETFs?
There are various types of ETFs (exchange-traded funds) available to investors, some of which include:
- Market Index ETFs: These ETFs track a specific market index, such as the S&P 500 or the NASDAQ Composite.
- Sector ETFs: These ETFs focus on specific sectors of the economy, such as technology, healthcare, or energy.
- Bond ETFs: These ETFs invest in a portfolio of bonds and provide exposure to fixed-income securities.
- Commodity ETFs: These ETFs invest in commodities such as gold, silver, oil, or agricultural products.
- International ETFs: These ETFs invest in foreign markets and provide exposure to international stocks and bonds.
- Style ETFs: These ETFs invest in stocks that have specific characteristics, such as growth or value.
- Inverse ETFs: These ETFs profit when the underlying index or asset goes down, making them a potential hedge against market declines.
- Leveraged ETFs: These ETFs use financial derivatives to amplify the returns of an underlying index, either up or down.
It’s important to note that each type of ETF has its own risk profile and suitability for investors, so it’s important to understand the underlying holdings and strategy before investing.
What are the advantages of ETF?
There are several advantages of ETFs (exchange-traded funds):
Diversification: ETFs offer investors diversification by holding a basket of different investments, such as stocks, bonds, or commodities. This diversification can help to reduce the risk of an investor’s portfolio.
Low cost: ETFs are typically cheaper than actively managed mutual funds because they are often passively managed, which means that they track an index rather than requiring active investment management. This lower cost is beneficial to investors, as it can help to increase returns over the long term.
Trading flexibility: ETFs are traded on an exchange, just like individual stocks. This means that they can be bought and sold throughout the trading day at market prices, allowing investors to enter or exit positions quickly.
Transparency: ETFs are required to disclose their holdings on a daily basis, providing investors with transparency into the fund’s portfolio. This information can help investors to make informed investment decisions.
Tax efficiency: ETFs are generally more tax-efficient than mutual funds, as they have a unique structure that allows them to avoid the tax implications of selling securities to meet investor redemptions. This can help to reduce the tax burden on an investor’s portfolio.
The advantages of ETFs make them a popular investment choice for both novice and experienced investors alike.
What are the disadvantages of ETF?
There are also several potential disadvantages of ETFs (exchange-traded funds) to consider:
Market risk: ETFs are not immune to market volatility, and their prices can be affected by market conditions. This means that an investor may experience losses if the market experiences a downturn.
Trading costs: While ETFs are generally cheaper than mutual funds, investors may still incur trading costs when buying and selling shares. These costs can add up over time and reduce overall returns.
Limited control: ETFs are passively managed, which means that investors have limited control over the fund’s investment decisions. This can be a disadvantage for investors who want more control over their investments.
Liquidity risk: While ETFs are generally more liquid than mutual funds, some ETFs may have low trading volumes, which can make it difficult to buy or sell shares at a favourable price.
Tracking error: While ETFs are designed to track the performance of a specific index or benchmark, there may be slight differences between the ETF’s performance and the performance of the underlying index. This is known as a tracking error and can result in lower returns for investors.
While ETFs have several advantages, it is important for investors to consider the potential disadvantages and weigh them against their investment goals and risk tolerance.