What are Exchange Traded Funds?
An exchange-traded fund (
) represents a basket of securities (that typically track an
index), and is listed and trades like stocks on an exchange. ETFs
can be traded throughout the day in amounts as little as one share.
ETFs combine the flexibility and ease of stock trading to the
benefits of traditional index fund investing.
How does an ETF differ from an index mutual
Index mutual funds also track baskets of securities. Unlike
mutual funds, which are priced once after the end of each trading
session, ETF prices change throughout the day and because they are
traded like shares, they do not have their net asset value (
) calculated every day like a mutual fund does.
What are the benefits of exchange traded funds versus
ETFs offer several advantages to the investors:
- Can be bought or sold at any time during the trading day
- Can be bought on margin
- Can be sold short
- Have lower fees than actively managed mutual funds
- Are generally more tax efficient compared with mutual
- Offer investors a wide range of sectors, geographies and
How is an ETF "created"?
The creation of an ETF begins with the sponsor, also known as
the manager filing a plan with the SEC, and on approval of the plan
executing an agreement with an authorized participant, also known
as a market maker or specialist, who in turn assembles the
appropriate basket of stocks and sends them to a specially
designated custodial bank for placing them in a trust. The
custodial forwards the ETF shares (which represent legal claims on
tiny slices of the basket of shares held in the trust) on to the
authorized participant. This is a
so-called "in-kind" trade of equivalent items, and thus
there are no tax implications.
What are the different types of ETFs?
While most ETFs track the performance of an index, there are
others that track a specific country, sector, industry, commodity,
or currency. We can call these ETFs "traditional ETFs". In 2008,
SEC began to authorize the creation of actively managed ETFs. We
can include ETFs such as leveraged, inverse or commodity futures-
linked ETFs in the category of "non-traditional ETFs".
Non-traditional ETFs involve the use of swaps, futures and other
What are the risks of investing in ETF?
A traditional ETF is not actively managed and thus has the same
risk as the basket of securities that it tracks. Additionally, a
fund may have some tracking error due to the costs incurred in
buying or selling securities or if there is some cash holding.
Non-traditional ETFs, which are backed by derivatives and
strategies and not assets, are much more volatile and risky
compared to the traditional ones. Such ETFs are generally not
suitable for "buy-and-hold" investors.
How do you find which ETF is best for your
Considering the large number of ETFs of all categories available
in the market, choosing the best one is not easy. Explicit cost
(expense ratio) and implicit cost (tracking error) are important
factors in distinguishing the better-managed ETFs from the worse
ones. The investors should also make sure that the fund has
sufficient assets, is traded frequently in good volumes and has
adequately diversified basket of stocks.
So, what is the bottom-line?
ETFs have come a long way since their birth in 1993, with the
introduction of SPDR ETF (to track the performance of S&P 500
Index), and it is estimated that more than $1.3 trillion has been
invested in these funds worldwide. They provide many benefits and
the investors, if properly educated about these investment
vehicles, can use them very easily and effectively to achieve their
investment aims. However, non-traditional ETFs should be analyzed
carefully before investing.
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