An Exchange Traded Fund (ETF) is a holding of multiple assets belonging to more than one class. The assets can include stocks, bonds, commodities and foreign currency. These can be, typically, really large funds with holdings running to even hundreds and thousands. As for the asset mix, it can be spread across diverse industries or specific to one. Similarly, there can be country-specific funds or one with a more international mix. ETFs, like stocks, are subject to the same market volatility conditions.
An investor in an ETF is not actually a direct owner of the fund. Instead, he joins other investors to indirectly stake a claim to the profits of the fund. They also have a claim to the residual value of the fund in the event of a possible liquidation.
The concept of ETF took shape and trading began in the early 1990s but grew in acceptance only after the 2008 recession. Till then, individual investors were mostly bought directly into stocks directly or invested in mutual funds. The stock market crisis after the Lehmann Brothers collapse pushed many investors from the mutual fund concept that aggressively aims to beat the index. Instead, the more passive nature of ETFs that aims to stay closer to the index. This focus of keeping tracking errors to a minimum appealed to many individual investors who would rather see returns lower than mutual funds but with less risk too.
Types of ETFs offered
There are many types of ETFs active in the market that investors can choose based on their preferences. We examine the main ones that are actively offered and traded.
This kind of ETF has a portfolio of regular equities and is traded on exchanges like stocks.
Also called Market ETFs, these follow a particular index and are based on its performance. These can be either the leading indices like NASDAQ or S&P 500 and can cover a diverse range of sectors and asset classes.
This includes various bonds issued by the government, state and local or municipal bonds. Other instruments like fixed income securities and bonds issued by corporates are also part of such ETFs.
These are ETFs specialising in physical commodities ranging from precious metals like gold to natural resources like crude oil to agricultural goods.
Currency based ETFs are of interest to investors who look for funds that deal in a specific currency or a basket of multiple currencies. This can be ideal for individual investors without previous exposure to the forex trading market who would like to include foreign currencies in their portfolio. Such ETFs offer portfolios that include all the leading currencies like the US Dollar, the Euro, the British Pound Sterling, and the Japanese Yen, among others.
Inverse ETFs are slightly different as these are modelled on the shorting technique where a stock is sold and bought later at a lower value. This kind of an ETF focuses on identifying stocks with a potential to fall and then making returns by shorting them.
Actively managed ETFs
As the name itself suggests, this type of ETF sees a much more active involvement by a team of investment experts with an aim to outperform the index rather than stay close to it. This includes more concerted efforts at picking stocks and more frequent trading.
This is another example that involves instruments like financial derivatives and more aggressive tactics like speculation and short-term trading to leverage investments for better returns.
Besides the above, there are specific ETFs that are offered in specific sectors like real estate, exchange-traded notes and alternative investment. There also are ETFs that specialise in either the US or a foreign market.
How does an ETF work?
Like stocks, an ETF too is traded at a stock exchange and comes with its own unique ticker symbol. It can be bought and sold all day long, unlike mutual funds that have to wait till day end.
The holding of an ETF, however, varies from the stocks issued by a company. ETF shareholding can increase or decrease regularly based on the trading activity. When new shares get added, the holding increases and when redemption happens, they decrease.
ETFs can be bought from both the regular offline brokers and the online ones too. The process involves buying or creation and selling or redemption. This is done with the involvement of Authorised Participants that comprises of large specialised investors.
With continuous creation and redemption of shares, the number of outstanding units keeps changing. This helps the market price of the ETFs to remain in line with the securities that the portfolio comprises of. As and when one asset increases in cost, the ETF’s share value also proportionately increases. In line with the performance of the fund, the shareholders are entitled to receive dividends.
Advantages of ETFs
1. Lower average costs
When investing in ETFs, there are multiple assets bought though the investor only pays for the number of times he buys into and sells out of the fund. This way, the transaction costs are limited unlike the per stock fees paid otherwise.
The expense ratio or the cost of fund management, therefore, is much lower. ETFs that track an index have low overheads.
2. Access to varied markets
ETFs have opened up the individual, retail investor to markets that had been, hitherto, inaccessible. This is true of certain asset classes, industries, forex and new age markets like cryptocurrency.
When an investor buys mutual funds, he does not always get to know where the money is allocated. There may be quarterly reports and updates but there is little clarity on the strategy adopted for investments or where the funds were deployed. But ETFs, usually, do a better job in disclosing their investments and share daily portfolio updates.
4. Tax efficiency
ETFs are generally more tax-efficient as the portfolio does not see frequent changes that could attract short-term capital gains.
ETFs are more liquid as they can be sold all day long unlike mutual funds that can only be traded at day end.
Disadvantages of ETFs
1. Investments in more complex asset classes
Some of the asset classes and sectors invested in may not be familiar to the average retail investor.
2. Settlement period
There is a 2-day waiting period between the sale and the settlement of the proceeds. This could hamper urgent access to funds.
3. Costs associated with trading
Investing smaller sums on multiple occasions invite transaction costs. Also, some ETFs like the Actively Managed ones tend to have significantly higher fees.
As an investment option, Exchange Traded Funds offers an interesting and appealing option for individual retail investors looking for alternatives to conventional stock trading and mutual funds.
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