Exchange-Traded Funds

What is an ETF?

An ETF, or exchange-traded fund, is an investment fund that tracks a specific asset, index or commodity, and can be easily traded like stocks. Rather than buying individual stocks, investors can put their money in a pooled fund that tracks an index like the FTSE 100 or the S&P 500. They may also focus on a sector like technology, or a commodity like gold. ETFs are usually passively managed, meaning they only track the gold price or the stock index, rather than being actively managed by a fund manager who buys and sells stocks in a bid to beat the market.

How do ETF’s work?

An ETF is bought and sold like a stock throughout the day and the price moves up and down in the same way. But unlike a stock, the number of ETF shares outstanding changes as shares are created or redeemed. This allows the price to remain largely in line with the underlying security or commodity it is tracking. That said, ETFs trade at market prices and can deviate from the price of the underlying asset depending on market forces.

Types of ETF

Some of the more common types of ETF track market indexes like the FTSE 100, ETFs that have a sector focus like financial or health-care focused funds, or ETFs that track a commodity like gold, coffee or oil. For commodity-focused ETFs, it’s worth finding out what you will own when buying shares. For example, does the ETF give you an ownership stake in a fund’s gold stockpile or not.

Why are ETFs popular

ETFs allow investment in an asset without having to buy into that physical asset. The pooled resource of the fund allows investors exposure to all these assets in one basket when investing individually would be prohibitive. They are also convenient because they can be traded throughout the day, whereas a traditional mutual fund is only traded once a day.

Benefits of ETFs

After an eventful year in the markets, investors are looking for ways to make their money grow. Exchange-traded funds (ETFs) offer a simple and straightforward way to invest in stocks or bonds without having to worry about picking individual securities. ETFs trade like stocks on the major exchanges, allowing them to be bought or sold at any time during market hours. This flexibility is one of many benefits that ETFs provide.

Diversification is a key benefit of ETFs because it enables exposure to a wide sector or index rather than an individual stock. However, the thematic nature of the investments (in a sector, an index or a commodity) still enables investors to target that sector or index.

ETFs are also a very transparent asset. It is always possible to check the price of the ETF. Also, the fund’s holdings are usually disclosed daily, compared with monthly or quarterly for mutual funds. Depending on individual circumstances there may be tax advantages to ETFs compared to mutual funds. Index-tracking ETFs have a lower turnover because they’re not actively managed so generate fewer capital gains than actively managed mutual funds. Also, the way ETF shares are created and redeemed also limits the number of taxable incidences, therefore lowering the tax burden.

What are the disadvantages of ETFs?

Depending on how you invest and how often, trading costs may be higher than in other funds or even investing in the individual stock itself. Also, there may be times when the bid/ask spread is wide. This means the price you can buy at is different to the price you can sell the ETF for, and the danger is buying too high and having to sell at a loss.
ETFs are designed to reflect the underlying commodity, sector or index but tracking errors can occur for various reasons and the ETF may not entirely reflect the underlying asset.