Exchange-Traded Funds (ETFs) – Some Basic Information

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An ETF expands to exchange-traded funds and is the name given to a liquid financial instrument that tracks commodities, bonds, index, or a group of assets like an index fund does. Any fund is usually made up from about 100 to 3000 different securities. An ETF can be traded like a regular stock on a stock exchange. This is where it is different from mutual funds. The prices of ETFs change throughout the day as they are being bought and sold at each and every instant. The value of the traded ETF is maintained close to what is called its net asset value. ETFs have high liquidity and the fees are also lower. These qualities make ETFs more attractive to individual investors. Because of the fact that ETFs get traded like stocks, the net asset value of ETFs is not calculated at the end of every day like it is done for mutual funds.

Exchange-traded funds are relatively new in the market when compared to mutual funds which have been in the market for a long time. They appeared in the market around the year 1993. Therefore, it is important for investors to have some basic information about ETFs before investing their money into funds of their choice.

What is exactly an ETF

Through an ETF it is possible for an investor to indirectly own assets such as bonds, shares of stock, gold bars, foreign currency, etc. ETF is a kind of fund that owns different types of underlying assets as mentioned above. The fund divides the ownership of the aforesaid into shares. The structure of the vehicle that carries these shares is different in different countries. There can be many structures that exist in a single country. The shareholders will not have direct ownership of these assets but are indirect owners.

ETF shareholders can enjoy a portion of the profits like the dividends that are paid out or the interest that is earned. If the ETF is liquidated, they are liable to get a residual value. ETFs can be traded like any other share on public stock exchanges.

Creation and Redemption Process of ETFs

The mechanism controlling the supply of ETFs are processes called creation and redemption. These processes involve the participation of large-sized specialized investors who are referred to as APs or authorized partners. These APs have big buying power and are large-sized financial institutions. These may be banks or other big investment companies. Only APs are given the power of being able to create or redeem ETFs. During the process of creation, the AP assembles different underlying assets and transfers this basket over to the fund in lieu of ETF shares that is newly created. During redemption, the AP returns the ETF shares to the fund and in turn gets back the basket of underlying assets. The holdings of the fund are revealed to the public every single day.

ETFs and Trading

What are Exchange-Traded Funds (ETFs)Both the ETFs and the underlying assets can be traded throughout the day. Traders make profits by taking advantage of the arbitrage opportunities that arise throughout the day. The trader may buy the ETF at a price that is less than that of the underlying securities, they will make the purchase and sell the underlying securities and keep the margin.

ETFs may also use derivative products and create leveraged or inverse ETFs. As an example, an inverse gold ETF would gain 1 percent in value for every 1 percent drop in the price of gold. However, in the case of leveraged ETFs, gives a multiple returns of the value of the underlying asset. For example, a 3x gold ETF would be able to return 3% for every 1% gain of the metal price. Negative 2x or 3x leveraged inverse ETFs are also possible.

ETFs and their advantages

Owning an ETF gives the investor many advantages. First of all the investor gets the chance to diversify index funds. There is also a chance to buy and sell and keep the margin. The investor has the liberty to purchase even one share as there is no stipulated minimum deposit. The expense ratios for ETFs are way less than that for mutual funds. The commission that a broker charges when buying or selling ETFs would the same as that would be charged for any other order. Taxation may be favourable for cash flows that are generated through purchase and sale of ETFs. This is because capital gains from the sales inside the fund are not passed on to the shareholders. Transaction and marketing, distribution and accounting costs of ETFs are also lower. There are ETFs that are available for every market sector, trading strategy and market niche.

Many investors invest in ETF shares as a means to long-term investment and for asset allocation. Other traders trade ETFs frequently to implement market timing strategies. An ETF can provide extensive diversification across an entire sector. The exposure to different varieties of markets and country-specific indices is also available.

Risks associated with ETFs

Synthetic ETFs are being viewed by regulatory authorities because of increased complexity and less transparency. ETFs that hold commodities and commodity futures are popular. Therefore, a large amount of these commodities are purchased and held by ETFs. In fact, they are big consumers of the commodities. Therefore, this causes an indirect effect on the price of the commodities.

Popularly Traded ETFs

  • One of the most popularly traded ETFs track the S&P 500 Index and is known as Spider.
  • IWM is yet another ETF that tracks Russell 2000 Index
  • QQQ tracks NASDAQ 100
  • DIA tracks Dow Jones Industrial Average
  • OIH is an ETF that tracks Oil companies, XLE tracks finance companies
  • BBH tracks biotech companies and XLF tracks financial companies
  • Commodity ETFs: USO tracks crude oil, GLD tracks gold, SLV tracks silver and UNG tracks natural gas. There are others as well.
  • There are ETFs that track foreign stock market indices as well as ETFs that track movement of foreign currencies in different world markets.
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