Exchange-Traded Funds: What They Are & How They Work

An investor is interested in investing in an Exchange-Traded Fund (ETF) because it is profitable. Coming with a diversified portfolio of assets and commodities, the ETFs bring stability to the investment market. There is also less risk with this investment as compared to individual stocks. Let’s explore more about ETFs, how they work, their advantages, types of ETFs, and risks to consider.

What is an Exchange-Traded Fund (ETF)?

A collection of bonds, commodities, and stocks in an investment is known as an Exchange-Traded Fund (ETF). During market hours, the collection of diverse assets can be traded on stock exchanges. Even though it is quite similar to individual stocks; however, there are some differences. ETFs are quite simple to manage, but there are diversifications of assets; hence, investors need to be aware and develop insight into them.

How ETFs Work?

Investors who are regulars in the trade market usually buy and sell ETF shares, which are available on the stock exchange market. The ETFs' prices fluctuate throughout the day based on supply and demand. The Net Asset Value (NAV) of the ETF and the market price are quite close in most cases. Even if the price drifts far from the NAV, the redemption or the creation process brings it back.

Basket of Assets - There is a collection of securities such as government bonds, commodities like gold and silver, and shares of different companies in an ETF.

Index Tracking - ETFs are mostly managed quite passively as they aim to mirror the performance of a specific market index, such as the S&P 500 and the Nifty 50.

Exchange Trading - ETFs are traded on stock exchanges, unlike mutual funds, which are bought and sold after the market closes. It allows the investors to sell or buy shares only during market hours.

Market Prices - based on the demand and supply of money or the underlying assets of the ETF throughout the day, the price of the ETF fluctuates.

Key Advantages of ETFs

There are several key advantages of Exchange-Traded Funds (ETFs), which highlight the significance for investors. You can learn about how they fit into your investment strategy if you are planning to invest in the emerging markets.

Diversification

ETFs have a diversified portfolio with a variety of assets in the fund, hence it reduces the risk of investing in a single stock. It has a positive impact on the trade deficit on the economy because it is more balanced than an individual stock.

Liquidity

It is quite easy to invest in an ETF as an investor who can buy and sell shares quickly. During market hours, it is one of the easiest investments to liquidate.

Low Costs

In most cases, ETFs have quite a low expense ratio compared to other mutual funds. The trading fees are also less in comparison to some of the best actively managed funds.

Transparency

The holdings of an ETF are quite transparent, as they allow investors to know what it is. The assets in the portfolio can be checked and evaluated by the investor before investing. 

Types of ETFs

There are different types of ETFs available in the market. Each of the funds is designed based on strategies, sectors, and assets. With diverse assets integration, you get to learn about the function of money. Below is a list of ETFs highlighting the differences between them: 

Index ETFs

These ETFs can track the specific market sectors like energy, healthcare, financials, and technology, or broad market indices. These ETFs bring exposure to targeted industries, thus indirectly expecting them to perform well. Example: Technology Select Sector SPDR Fund (XLK)

Commodity ETFs

These ETFs help investors invest in commodity futures or in physical commodities like gold, silver, agricultural, or oil. When there is inflation in the market funds, this ETF is useful. Investors often use them to hedge against market volatility. Example: SPDR Gold Shares (GLD)

Bond ETFs

These ETFs hold a diversified portfolio of bonds, government, municipal, and corporate. It is an income-generating investment as it is a lower risk. Example: iShares Core U.S. Aggregate Bond ETF (AGG)

Risks to Consider

Considering it is a collection of assets, it comes with a set of risks. As an investor, you must consider all the risks and learn about them. It will help you to know how they work and whether you can consider them as an investment option.

Market Risk

Just like any investment, ETF prices are directly impacted by market fluctuations, hence they can either rise or decline. Not every investor can benefit from the ETF, especially if the market is not stable, because with the trade deficit, there will be a loss.

Tracking Error

There can be a tracking error if there is a passive ETF. It might not be able to effectively track the underlying index.

Bid-Ask Spread

There are buying (bid) and selling (ask) prices of an ETF, so an investor will see that there is a small price difference between the two. 

Ready to Invest in an Exchange-Traded Fund?

In conclusion, ETF is a significant type of investment if you are into stock exchange or future trading. If you want to make an investment where the risk is limited, but there is a high possibility of increasing return from the ETF investment, this is it. Additionally, ETF also helps in evaluating the market, the rise and fall, effectively warning investors of major fluctuations.

Read More

• The Role of the World Trade Organization
• Comparative Advantage in Trade
• What do Trade Barriers Mean?
• Globalization vs Protectionism - Key Concept in International Trade
• What is Trafe Lifecycle? - 8 Stages Discussed

Frequently Asked Questions (FAQs) on Exchange-Traded Fund

Is ETF good or bad?

ETFs are not ideal for every investor; hence, you cannot judge it about whether it is good or bad. They are considered low-cost instruments that track indices effectively. Additionally, they also offer flexibility very similar to stocks. 

What was the first ETF in the world?

The first exchange-traded fund (ETF) in the world was introduced on 9 March 1990, called the birth of Toronto 35 Index Participation Units (TIPs).

Is ETF high risk?

Inherently, ETFs are high risk because the risk level depends on the underlying assets. However, several diversification benefits help mitigate the risks compared to investing in individual stocks.

What is the difference between ETFs and stocks?

The basic difference between ETFs and individual stocks is that ETFs have a built-in diversification, which helps reduce risk. Compared to ETFs, individual stocks carry significant risks. 

Can I sell ETFs anytime?

You can sell an ETF anytime during the trading hours of the market. ETFs are traded on stock exchanges, offering greater trading flexibility and liquidity, which is typically done during trading hours.