What are Exchange-Traded Funds or ETFs?

An Exchange-Traded Fund (ETF) is an investment fund traded on stock exchanges, similar to stocks. It tracks an index, a commodity, bonds, or a portfolio of assets, similar to an index fund. Unlike mutual funds (UK: unit trusts), an ETF trades continuously at market prices.

The US Securities and Exchange Commission (SEC) says the following about ETFs:

“Exchange-traded funds (ETFs) are SEC-registered investment companies that offer investors a way to pool their money in a fund that invests in stocks, bonds, or other assets. In return, investors receive an interest in the fund. Most ETFs are professionally managed by SEC-registered investment advisers. ETFs are not mutual funds. But, they combine features of a mutual fund.”

Key Characteristics of Exchange-Traded Funds

There are several key features of ETFs, including:

  • Diversification

ETFs hold a diversified portfolio of assets, which reduces the risk compared to investing in individual stocks.

  • Liquidity

They are traded on stock exchanges and can be purchased and sold during trading hours.

  • Transparency

ETF holdings are typically disclosed on a daily basis, giving investors clarity.

Types of ETFs

There are several types of ETFs, including:

  • Stock ETFs

They track specific stock market indices or sectors.

  • Bond ETFs

This type invests in a variety of bonds.

  • Commodity ETFs

They track the prices of commodities such as gold, oil, silver, natural gas, copper, corn, wheat, and soybeans.

  • Thematic ETFs

These funds focus on certain themes or investment techniques, such as renewable energy or innovative technology.

Advantages

There are several advantages to investing in ETFs, such as:

  • Cost-Effective

There are usually lower fees than in actively managed funds.

  • Tax Efficiency

ETFs, most of the time, have lower capital gains tax rates than other investment funds.

  • Flexibility

You can sell and buy in the same way as stocks.

  • Compounding

Over time, regularly investing a certain amount each month can result in substantial compound growth.

Exchange-Traded Funds depiction plus definition
Image created by Market Business News.

Things to Consider

If you’re an investor, there are several things you should take into consideration, such:

  • Market Risk

Just like any other investment, ETFs are not risk-free.

  • Expense Ratio

Most of the time, the fees are low, but they can vary between ETFs.

  • Tracking Error

An  ETF may diverge from the expected performance of its benchmark index or referenced assets.

The Future of Exchange-Traded Funds

The ETF market is set to grow, with more variety and smarter technology drawing in new investors and companies, broadening access to different sectors and investment styles.

Written by Nicolas Perez Diaz