In this article, we will explain what ETFs are and how they work. We will also briefly cover their advantages and disadvantages.
What Is an ETF?
An exchange-traded fund, or ETF, is a type of investment fund that is traded on an exchange. An ETF has an associated price and a ticker and can be bought and sold like a stock via a traditional brokerage account throughout the trading day.
They can be structured to track an underlying asset or index, so anything from an individual commodity or asset, such as gold, to a basket of assets, such as the well-known S&P 500. Therefore, they can contain various types of investments, including but not limited to commodities, stocks, or bonds.
One of their greatest advantages is that they allow investors to diversify their investment portfolios without actually owning the assets themselves. For example, as the name suggests, a Bitcoin ETF tracks the price of Bitcoin, so those interested can invest in the cryptocurrency without directly owning it.
They usually have lower fees than other types of funds, as well as varying levels of risk. ETFs appeared in the U.S. in 1993, when State Street Capitol launched SPDR S&P 500 ETF, and they are listed on exchanges like the Nasdaq, the New York Stock Exchange, and the Shanghai Stock Exchange.
ETFs are often associated with mutual funds, but one major difference is that just like stocks, the price of an ETF’s share changes throughout the trading hours as the shares are bought and sold on the market. Mutual funds, on the other hand, are priced just once a day.
How Do ETFs Work?
Simply put, an ETF works as follows:
An ETF provider, which is a company that makes exchange-traded funds, designs a fund to track the performance of various underlying assets. It then creates a basket of them using a unique ticker.
As an investor, you can then buy and sell a share of that basket. The process is similar to buying and selling shares, and in the case of ETFs, investors can buy units in an ETF through a stockbroker. The ETFs are then traded throughout the trading hours on an exchange, much like a stock.
Some popular ETF providers include Vanguard, iShares by BlackRock, and State Street.
Advantages and Disadvantages of ETFs
ETFs come with several benefits, including the following:
- Ease of use – ETFs are easy to trade, and investors can buy and sell at any time during the trading hours of the exchange. Plus, they can buy a basket of shares or assets in a single trade.
- Diversification – ETFs enable investors to access many stocks across various industries that may otherwise be expensive or difficult to access.
- Transparency – Index-based ETFs publish their holdings daily, unlike mutual funds that do so monthly or quarterly. In addition, an investor can always search the price activity for a particular ETF.
- Low cost – many ETFs have a low management expense ratio (MER) and fewer broker commissions.
However, ETFs are not free of disadvantages. Some of them include:
- Currency risk – in case an ETF invests in international assets, the currency movements impact the investor’s returns.
- Liquidity risk – some ETFs invest in illiquid assets, which can hinder transactions.
- Tracking errors – given that ETFs track the price of the underlying index, there is the risk of technical issues occurring, which can create discrepancies.
ETFs are investment vehicles designed to track the performance of a particular asset or group of assets. Their success is mainly due to the ease of use they ensure as investors can diversify their portfolios without actually owning the underlying assets.
There are many types of ETFs, such as bond, commodity, market, inverse, and actively-managed ETFs, which enables investors to access stocks from different sectors. However, even if they are easier to trade, they do have some drawbacks, including potential liquidity issues.