An Exchange Traded Fund (ETF) is a type of investment fund traded on stock exchanges. It is designed to track the performance of a particular index, commodity, or basket of assets. They are popular among investors because they offer a low-cost, diversified way to invest in a wide range of assets. An exchange-traded fund (ETF) is marketable security, meaning that its share price allows it to be readily bought and sold on exchanges throughout the trading day and that it can also be sold short. ETFs were first introduced in the United States in the early 1990s and have become a popular investment vehicle worldwide. According to the Investment Company Institute (ICI), the global ETF market had more than $10 trillion in assets under management as of the end of 2020.
ETFs are a form of fund that hold multiple underlying assets, as opposed to a single asset like stocks. ETFs can be a popular option for diversification because they contain multiple assets. ETFs can therefore hold various investments, including equities, commodities, bonds, or a combination of these. A single ETF can hold hundreds or thousands of securities across multiple industries or focus on a single industry or sector. For instance, ETFs focusing on the banking industry comprise stocks from various banks across the sector.
What Are The Various Types of Exchange Traded Funds (ETF)?
Each ETF type has its investment objective and approach. Here are some of the most prevalent ETF types:
- Equity ETFs: These ETFs invest in a portfolio of stocks intending to replicate the performance of a particular stock market index. It can be an attractive investment option for investors seeking to diversify their portfolio, gain exposure to a particular market or sector, and benefit from ETFs’ flexibility, liquidity, and low costs.
- Fixed Income ETFs: These ETFs invest in a portfolio of bonds or other fixed-income securities to replicate the performance of a particular bond market index, such as the Barclays Capital Aggregate Bond Index.
- Commodity ETFs: These ETFs invest in a portfolio of physical commodities, such as gold, silver, oil, or agricultural products, or in futures contracts or derivatives. Investing in Gold ETFs is a popular way to gain exposure to gold as an asset class, providing several advantages over physical gold investment.
- Currency ETFs: These ETFs invest in a portfolio of currencies intending to replicate the performance of a particular currency index, such as the U.S. Dollar Index.
- Alternative ETFs: These ETFs invest in alternative investments, such as real estate, infrastructure, or private equity, which are not typically available to retail investors. They are designed to provide exposure to these asset classes more liquid and transparently.
- Leveraged and Inverse ETFs: These ETFs use derivatives to amplify or inverse the daily returns of a particular index or asset class. The objective of leveraged ETFs is to provide returns that are two or three times the daily performance of the underlying index. In contrast, the objective of inverse ETFs appears to provide returns that are the opposite of the daily efficiency of the underlying index.
- Sector ETFs: These ETFs invest in a portfolio of stocks or other securities within a particular economic sector, such as technology, healthcare, or energy. They are designed to provide targeted exposure to specific sectors of the economy. By investing in CPSE ETF, investors can gain exposure to a diversified portfolio of CPSEs cost-effectively, with the added benefit of liquidity and ease of trading on the stock exchanges.
How Do ETFs Work?
ETFs are structured as open-ended investment companies or unit investment trusts. They issue shares traded on stock exchanges, just like individual stocks. The market determines the price of an ETF share and may trade at a premium or a discount to the underlying Net Asset Value (NAV) of the assets held by the fund. The shares of the ETF represent ownership of a proportionate share of the underlying assets in the fund.
ETFs can be bought and sold on stock exchanges throughout the day, just like stocks, making them a popular choice for investors who want exposure to a particular market sector or asset class without buying individual stocks. Additionally, ETFs generally have lower fees and expenses than traditional mutual funds. They hold various assets, including stocks, bonds, commodities, and currencies. Some ETFs, such as the S&P 500 or the Dow Jones Industrial Average, are designed to track a broad market index. Others track specific sectors, such as technology or healthcare, or regions, such as emerging markets.
What Are The Advantages of Exchange Traded Funds (ETF)?
Some of the few advantages of investing in ETFs are explained below:
- Diversification: ETFs provide investors with the opportunity to invest in a diverse portfolio of assets. This can assist in mitigating risk and increasing potential returns.
- Low costs: ETFs typically have lower fees than actively managed mutual funds, making them an attractive option for cost-conscious investors.
- Liquidity: ETFs are traded on stock exchanges, which means they can be bought and sold throughout the trading day, just like individual stocks.
- Tax efficiency: ETFs are generally more tax-efficient than mutual funds because they typically have lower turnover and can be structured to minimise capital gains distributions.
What Are The Disadvantages of Exchange Traded Funds (ETF)?
There are also some disadvantages to investing in ETFs:
- Limited control: Because ETFs are passively managed, investors have limited control over the assets held by the fund.
- Market risk: Like any investment, ETFs are also subject to market risk. If the underlying assets perform poorly, the value of the ETF shares may decline.
- Tracking error: ETFs that track a specific index may not perfectly replicate the performance of that index due to tracking error.
- Lack of transparency: Some ETFs may not disclose their holdings daily, making it difficult for investors to know exactly what they are investing in.
ETFs have become a popular investment option for investors around the world. They offer a low-cost, diversified way to invest in various assets. However, like any investment, ETFs have advantages and disadvantages, and investors should consider these factors carefully before investing.