What Is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Exchange Traded Fund or ETF invests in diversified securities, including bonds, equity, commodity, an index, or a bouquet of equity assets such as an index fund. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to follow specific investment strategies.
The units of an ETF are usually bought and sold through a registered broker of a recognized stock exchange. The stock exchange lists the units of an ETF, and the NAV (Net Asset Value) varies per the market movement. Unlike mutual funds that have NAV calculated at the end of each trading day, an ETF’s price changes throughout the day. ETF provides the benefits of diversification of index funds plus the flexibility of a stock.
The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index and remains an actively traded ETF today.
How do Exchange Traded Funds (ETFs) Work?
An ETF usually represents a basket of products/assets. This type of investment tends to own the assets underlying the fund. Such assets include but are not limited to company stocks, oil futures, gold, foreign currency, and bonds.
Gold and index-linked ETFs are the most common types available to individual investors in India. The ETF divides its total assets into smaller units termed shares, which can be traded on the exchange.
Thus the current trading value of an ETF is based on the applicable value of net assets that the Exchange Traded Fund owns. The shareholders of an ETF are also liable to receive profits from the underlying assets in the form of dividends or interest earned.
In simpler terms, an ETF may be considered similar to a mutual fund. It can be bought and sold on the stock exchange, and its trading value can change in real-time.
Types of ETFs
Various types of ETFs are available to investors that can be used for income generation, speculation, and price increases and to hedge or partly offset risk in an investor’s portfolio. Here is a brief description of some of the current ETFs available on the market.
Passive and Active ETFs
Exchange Traded Funds are generally characterized as either passive or actively managed. Passive Exchange Traded Funds aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more specific targeted sector or trend.
Actively managed Exchange Traded Funds typically do not target an index of securities but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds have benefits over passive Exchange Traded Funds but tend to be more expensive to investors. We explore actively managed ETFs below.
1.Bond ETFs-
Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government, corporate, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.
2.Stock ETFs-
Equity Exchange Traded Funds comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, including high performers and new entrants with growth potential. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.
3.Industry/Sector ETFs-
Industry or sector Exchange Traded Funds focus on a specific sector. For example, an energy sector Exchange Traded Funds will include companies operating in that sector. The idea behind industry Exchange Traded Funds is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector.
One example is the technology sector, which has recently seen an influx of funds. At the same time, the downside of volatile stock performance is also curtailed in Exchange Traded Funds because they do not involve direct ownership of securities. Sector Exchange Traded Funds are also used to rotate in and out of sectors during economic cycles.
3.Commodity ETFs-
As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns.
For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.
4.Currency ETFs-
Currency Exchange Traded Funds are pooled investment vehicles that track the performance of currency pairs consisting of domestic and foreign currencies. Currency Exchange Traded Funds serve multiple purposes. They can be used to speculate on the prices of coins based on political and economic developments in a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation. There’s even an Exchange Traded Funds option for bitcoin.
5.Inverse ETFs-
Inverse Exchange Traded Funds attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse Exchange Traded Fund uses derivatives to short a stock. Essentially, they are bets that the market will decline.
When the market declines, inverse Exchange Traded Funds increases proportionately. Investors should know that many inverse Exchange Traded Funds are Exchange-Traded Notes, not actual ETFs. An ETN is a bond that trades like a stock and is backed by an issuer such as a bank. Check with your broker to determine if an ETN is a good fit for your portfolio.
6.Leveraged ETFs-
A leveraged Exchange Traded fund seeks to return some multiples on the return of the underlying investments. For instance, if the S&P 500 rises by 1%, a 2× leveraged S&P 500 ETF will return 2%. These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return.
How to Buy ETFs
Investing in ETFs has become fairly easy with various platforms available to traders.
Click Here to Begin Investing In ETFs.
Benefits of ETFs (Exchange Traded Funds)
1.They Have A Wider Scope For Diversification
The most significant advantage of an ETF is that it gives the investor wider exposure to groups of equities, styles, or market segments. Compared to one single stock, ETFs can keep track of a broader segment of stocks and/ or even mimic country-wise returns or returns from numerous countries. For instance, one could study an ETF from BRIC, i.e., the combination of Brazil, Russia, India, and China. The ETF comes with lower fees and assumes the qualities of any equity investment that can be traded easily.
2.Lower Fees
ETFs are generally passively managed and have considerably low expense ratios to their credit compared to other assorted managed funds. It is often seen that the expense ratio of a mutual fund is generally higher because of additional costs like management fees, expenses for shareholder accounting at fund levels, overhead expenses such as marketing costs, salaries to fund managers, and load fees pertaining to distribution and sales.
3.Flexibility of Trading
A significant advantage of ETFs is that they are easily tradable like any other stock, even though they provide the holder with all benefits of diversifying. You can purchase ETFs on margin and sell short; their prices are updated as and when they move to allow you to sell or buy at the opportune moment. This is a significant advantage over open-ended mutual funds and the prices of which are available at the day’s end on NAV or net asset value; ETFs allow risk management through futures trading and options, similar to stocks; As they trade like stocks, ETFs allow you to monitor daily changes of the commodities sector by way of a ticker symbol. Many stock-specific websites are equipped with better interfaces than commodity websites to manipulate charts with applications for mobile devices.
This flexibility of trading makes ETF share trading and portfolio management a snap. You can easily move your money among specific assets like bonds, stocks, or commodities. All it takes is an hour for investors to obtain their allocation into investments they desire, with the option of changing their allocation the next hour. This isn’t exactly applicable to open-ended mutual funds, which take several days, and the NAV remains unknown till the day’s end. You won’t know exactly the amount receivable when you sell your shares of an open-ended fund or, for that matter, how much to invest in another open-ended fund.
The trading flexibility that comes with ETFs gives their investors the added benefit of making timely decisions on their investments and placing their orders in numerous ways. When investing in ETFs, you have all the trade combinations characteristic of investing in equity stocks, including limit and stop-limit orders. You can even purchase ETFs on margin after taking a loan from your broker. You can even short-sell by borrowing securities from your broker and selling these securities simultaneously. This is usually done to buy them back when their prices drop later.
4.Immediate Reinvestment Of Dividends
Dividends given out by companies belonging to an open-ended ETF are immediately reinvested, whereas the timing may vary for indexed mutual funds. However, it needs to be borne in mind that dividends generated by unit investment trust-based ETFs are not reinvested automatically. This creates what is known as the dividend drag.
5.Limited Exposure to Tax on Capital Gains
ETFs are known to be more tax-friendly as compared to mutual funds. This is because the bulk of capital gains tax is payable on the sale and depends solely on the investor. The ETF may buy or sell shares in an attempt to copy the basketful of shares it happens to be tracking. Any capital gains arising from in-kind transfers in ETFs don’t give rise to tax charges, making it more favorable than mutual funds. The latter need to distribute all capital gains among their shareholders if securities are sold at profits. The distribution of such capital gains is based on the proportion the holder invests while also becoming taxable as a capital gain. If holders of any other mutual funds sell their units before the record date, the holders remaining invested in the said fund take upon themselves the burden of capital gains and end up paying taxes even though the fund’s overall value may be reduced.
6.Lower Discounts or Premium Prices
Trading in ETFs takes place throughout daily trading hours at prices that are more or less close to the prices of underlying securities. Thus, arbitrage brings prices back on track if prices are significantly lower or higher than net asset values. This differs from close-ended index funds as ETFs trade on demand and supply, allowing market makers to grab profits based on price discrepancies.
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