What Is An Exchange Traded Funds (ETF)? Definition Of ETF

ETFs or exchange traded funds are similar to index mutual funds. However, they trade just like stocks.

An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same way a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.

Types Of ETFs

There are a number of types of ETFs, each with a different investment focus. Following are some of the most common ETFs.

Diversified passive equity ETFs are designed to mirror the performance of widely followed stock market benchmarks such as the S&P 500, the Dow Jones Industrial Average, and the MSCI Europe Australasia Far East (EAFE) indexes. Footnote 1 Major index-based ETFs have tended to follow their performance benchmarks closely.

Niche passive equity ETFs such as those that mirror the sector subsets of the S&P 500 or the small companies of the Russell 2000, may offer investors focused exposure to help them fine-tune their portfolio strategies. As with diversified passive funds, these niche portfolio funds are generally made up of the same stocks as those used to calculate their reference indexes.

Active equity ETFs allow their managers to use their own judgment in selecting investments, rather than rigidly pegging to a benchmark index. Active ETFs may offer the potential to outperform a market benchmark but may also carry greater risk and higher costs.

Fixed-income ETFs focus on bonds rather than stocks. Major fixed-income ETFs tend to be actively managed, but have relatively low turnover and generally stable portfolios.

How ETFs work

An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol, and intraday price data can be easily obtained during the course of the trading day.

Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.

Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.

Advantages of ETFs The appeal of ETFs:

Easy to trade - You can buy and sell any time of the day, unlike most mutual funds that trade at the end of the day.

Transparency - Many ETFs are indexed based; index-based ETFs are required to publish their holdings daily.

More tax efficient - ETFs typically generate a lower level of capital gain distributions relative to actively managed mutual funds.

Trading transactions - Because they are traded like stocks, investors can place a variety of order types (e.g., limit orders or stop-loss orders) that can't be made with mutual funds.

Disadvantages of ETFs However, ETFs do have drawbacks, including:

Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives to investing directly with a fund company in a no-load fund.

Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread.

Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies.

Settlement dates: ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale aren't technically available to reinvest for 2 days.