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ETF Education

What are Exchange Traded Funds?
 

An exchange-traded fund (ETF) 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 fund?

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 (NAV) calculated every day like a mutual fund does.

What are the benefits of exchange traded funds versus mutual funds?

 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 funds
  • Offer investors a wide range of sectors, geographies and strategies

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 derivatives.

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 portfolio?

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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