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Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs)An exchange-traded fund (ETF) is an investment fund traded on stock exchanges throughout the trading day, similar to stocks. It contains investments such as bonds, commodities, or stocks. ETFs may be attractive to invest in due to low costs, stock-like features, and tax efficiency.

What Are Exchange Traded Funds (ETFs)?

ETFs are securities that behave the same way as a specific index or a collection of different securities. An ETF owns the underlying assets and splits the ownership of those assets into shares. An ETF can either own thousands of stocks across various industries or be limited by one industry or sector.

The name “exchange-traded fund” means that it is traded on an exchange just like stocks, i.e. bought and sold with price changes. As the ETFs are bought and sold during the day, the price of their shares will fluctuate.

Types of ETFs

There are different types of exchange-traded funds available to investors, for example:

  • Bond. These are ETFs that invest in bonds and have quite reasonable trading commissions. However, if bought and sold through a third party, the investor may incur fees that eliminate this advantage.
  • Commodity. This type of ETFs invests in commodities such as agricultural products, crude oil, or gold. Despite being simple and efficient for trading, some factors that affect the price of commodities may not be transparent enough.
  • Currency ETFs invest in foreign currencies such as euro or pound.
  • Index. Most exchange-traded funds are index funds that try to reproduce the performance of a certain index be based on bonds, commodities, currencies, or stocks. An index ETF tracks the performance of an index by keeping either the index contents or a sample of securities in the index in its portfolio.
  • Industry ETFs track a specific industry such as banking, technology, or the oil and gas sector.
  • Inverse. This type of exchange-traded funds tries to earn gains from stock declines by shorting the stocks, i.e. selling a stock, expecting a decline in value, and then purchasing it again at a lower price. Investors should be aware that many inverse ETFs are ETNs (exchange-traded notes) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank.
  • Leveraged. Leveraged exchange-traded funds (LETFs) are a type of funds that tries to achieve returns that are more sensitive to market movements than non-leveraged ETFs. The most common way to construct leveraged ETFs is by trading the futures contracts.

Benefits of Exchange Traded Funds

Exchange traded funds bring the investors the following advantages:

  • Lower average costs and fewer commissions. It is expensive for an investor to individually buy all stocks in an ETF. Investors need only one transaction to buy and one transaction to sell, resulting in fewer broker commissions. Some brokers even offer to trade without commission on specific low-cost ETFs.
  • No minimum deposit requirements. As a result, an indexed stock ETF gives investors an opportunity to diversify an index fund as well as buy on margin, sell short, and purchase as little as one share.
  • Entitlement to dividends and earned interest. Dividends are a portion of earnings that companies pay investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as dividends or earned interest, and may receive a residual value in case of fund liquidation.
  • Tax efficiency. Most buying and selling takes place via an exchange. As a result, there is no need for the ETF sponsor to issue new shares each time an investor wishes to buy or redeem the shares every time an investor wishes to sell. On the contrary, in case of a mutual fund, every time an investor sells their shares, they sell it back to the fund, and the fund’s shareholders must pay a tax.
  • Stock-like features. Unlike a mutual fund, which is bought or sold at the end of a trading day, it is possible to trade ETFs every time the market is open. ETFs trade on the market, so the investors can perform the same types of trades that they can with a stock.

Drawbacks of ETFs

Like most investments, exchange-traded funds have disadvantages along with advantages, such as:

  • Low trading volumes. The low trading volumes can eliminate the benefit of buying an ETF over equity or index is eliminated.
  • Inactivity. Some ETFs are not as actively traded as other types of funds due to the regional or sectoral issues. Therefore, it may be reasonable for some investors to consider managed funds with higher levels of activity.
  • Long investment horizon. Exchange traded funds imply trading opportunities during a day. It is beneficial only for short term traders but not for long term ones. International limitations. Unlike the United States, other countries have very few ETF offerings.
  • An overwhelming number of choices. Because there are too many ETFs, it can be confusing for people who are thinking of investing in them. A possible solution is sticking with the biggest, most popular ETFs tied to familiar indexes.
  • Lack of diversification. Not all exchange-traded funds are diversified because the funds might focus only on a single industry or several stocks.
  • It is possible to actively manage some ETFs, which leads to greater fees than with passively managed funds that track an index.

Summary

Exchange traded funds own the underlying assets and split this ownership into shares. ETFs are traded on an exchange like stocks, meaning that they are bought and sold with price fluctuations. Mostly depending on what the ETFs are invested in, there are several types of ETFs: bond, commodity, currency, index, industry, inverse, and leveraged. The advantages of exchange-traded funds are lower average costs, no minimum deposit requirements, entitlement to dividends and earned interest, tax efficiency, and stock-like features. The disadvantages are low trading volumes, inactivity, long investment horizon, international limitations, an overwhelming number of choices, and lack of diversification.