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What is Exchange Traded Fund (ETF)?

WHAT IT IS:

An Exchange Traded Fund (ETF) is simply a security that tracks an index, the group of stocks, commodity, etc. but is traded like a stock on a stock exchange.

These investment vehicles allow investors a convenient way to purchase a broad basket of securities in a single transaction. Essentially, ETFs offer the convenience of a stock along with the diversification of a mutual fund.

The first big point to note is that an ETF is NOT a mutual fund because ETFs prices change throughout the day just like a stock.

The largest ETFs typically have higher average daily volume and lower fees than mutual fund shares which makes them an attractive alternative for individual investors.

HOW IT WORKS:

Whenever an investor purchases an ETF, he or she is basically investing in the performance of an underlying bundle of securities -- usually those representing a particular index or sector. Unit Investment Trusts (UITs) are often organized in the same manner. However, the unusual legal structure of an ETF makes the product somewhat unique.

ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a stock exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value (NAV).

Exchange-traded funds don't sell shares directly to investors. Instead, each ETF's sponsor issues large blocks (often of 50,000 shares or more) that are known as creation units. These units are then bought by an "authorized participant" -- typically a market maker, specialist or institutional investor -- which obtains shares of the underlying securities and places them in a trust. The authorized participant then splits up these creation units into ETF shares -- each of which represents a legal claim to a tiny fraction of the assets in the creation unit -- and then sells them on a secondary market.

BENEFITS:

  • An important benefit of an ETF is the stock-like features offered. A mutual fund is bought or sold at the end of a day's trading, whereas ETFs can be traded whenever the market is open
  • ETFs offer tax advantages to investors due to fewer capital gains.
  • The capital gains tax on an asset in an ETF is only paid when the entire ETF is sold, not while you are holding the ETF.
  • ETF investors can transact at the price prevailing at that point in time.
  • Low Cost: ETF investors do not have to bear any loads (as in the case of MFs) and brokerage commission is also low.
  • Liquidity: Whereas traditional mutual funds are only priced at the end of the day, ETFs can be bought and sold at any time throughout the trading day. Many have average daily trading volumes in the hundreds of thousands (and in some cases millions) of shares per day, making them extremely liquid.
  • LIMITATIONS:

    • The securities that an ETF tracks are largely fixed, so investors that prefer active management will probably find ETFs wholly unsuitable.
    • A major consideration before investing in ETFs is the potential that fund companies can go bust anytime.
    • ETFs trade as stocks, each ETF purchase will be charged a brokerage commission. For those that make regular periodic investments, these recurring commissions might quickly become cost-prohibitive.
    • Brokers and sub-brokers tend to wean away potential investors from ETFs as they probably get paid less commission here than in regular MFs. Hence, one must get several opinions from various brokers before investing and try to understand the commission scenario.
    • DIFFERENCE BETWEEN ETFs & MUTUAL FUND:

      ETFs

      Mutual Funds

      Trade during a trading day

      Trade at closing NAV

      Low operating expenses

      Operating expenses vary

      No investment minimums

      Most have investment minimums

      Tax-efficient

      Less tax-efficient

      No sales loads

      May have a sales load

      TYPES OF ETFs:

      • Index ETFs: Most ETFs are index funds that attempt to replicate the performance of a specific index. Indexes may be based on stocks, bonds, commodities, or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.
      • Stock ETFs: Stock ETFs can have different styles, such as large-cap, small-cap, and growth. ETFs can also be sector funds. These can be broad sectors, like finance and technology, or specific niche areas, like green power.
      • Bond ETFs: Exchange-traded funds that invest in bonds are known as bond ETFs.
      • Commodity ETFs: Commodity ETFs invest in commodities, such as precious metals, agricultural products, or hydrocarbons. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries.
      • Currency ETFs