What is an ETF?
An exchange-traded fund or ETF is a type of fund that owns a number of assets and divides ownership of itself into shares that are held by shareholders. It is a diversified collection of assets that tracks an index like an index mutual fund, but trades on an exchange like individual stocks.
Shareholders who own ETFs indirectly own the assets of the funds and are entitled to get annual reports on the securities held in the fund. These shareholders are also entitled to a share of the profits generated by the fund (i.e. interest, dividends, and even residual value in case the fund is liquidated).
Unlike mutual funds, ETFs do not need to be sold or redeemed at the net asset value (NAV), thus they can be traded throughout the day directly through a broker. Computing the NAV of ETFs is not necessary because of its arbitrage mechanism which is designed to keep the funds trading close to its net asset value.
One of the unique qualities of ETFs is the mechanism known as “creation and redemption”. Only authorized participants (APs) can create or redeem units of ETFs. These APs are large financial institutions with a high degree of buying power, which are also called “market makers”.
Read more about mutual funds.
Characteristics of ETFs
Stock-like features – A specific trait of ETFs that sets it apart from mutual funds is the capacity to short sell, place stop-loss, limit orders, and buy on margin that makes it very similar to individual stocks.
Diversification – Just like mutual funds, an ETF potentially holds hundreds to thousands of individual stocks and bonds. Investing in ETFs is a great way to start with an already diversified portfolio, thus minimizing the risk involved in investing only in a limited number of stocks.
Management – ETFs are also a great investment even to those who do not know much about the market or doesn’t have enough time to manage their own assets as they are managed by fund experts.
Convenience – As mentioned earlier, ETFs do not need to be bought or sold at their NAV, thus allowing them to be traded at any time of the day through a broker on a major stock exchange.
Lower cost – Funds that track an index, like ETFs and index mutual funds, generally have lower expense ratios than conventional mutual funds.
Tax efficiency – Like index mutual funds, ETFs are tax-efficient, thus resulting in more tax savings.
Lower minimum – An ETF can be bought for as low as the cost of one share, giving the opportunity to start investing in a diversified portfolio with less capital.
Liquidity – Most investors have a part of capital allotted for ETFs since it is considered a safe investment. Due to this, ETFs typically has higher daily liquidity than mutual funds.
You may have noticed that ETFs have a very striking similarity to index mutual funds that leaves you wondering: “which investment is right for me?”. Choosing which one is the best can be tricky, but it can be solved by understanding your investment horizon. Index mutual funds are best for passive investors since they typically outperform other funds in the long run, while ETFs, on the other hand, are more preferred by active investors because of their capacity to be traded at any time of the day and its high liquidity that can produce huge price movements at small periods of time.
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