What Are ETFs and How Do ETFs Work?

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Updated: 08 September 2020

ETFs/exchange-traded funds are marketable securities tracking assets such as an index, a commodity, bonds or basket of assets such as an index fund. To understand what are ETF, it is essential to study how they work. An ETF trades much like a common stock on a stock exchange. The crux of how ETFs work is by charging lower fees and displaying higher everyday liquidity, as compared to mutual fund shares. ETFs experience intra-day changes in price as sale and purchase of these securities takes place. As it trades like a stock, an ETF lacks a NAV.

  • ETFs own underlying assets; shares define ownership of the assets
  • ETFs trade like stocks, but are unlike MF on numerous scores
  • Many different types of ETFs include sector ETFs, forex ETFs, commodities ETFs, style ETFs and more
  • ETFs come with advantages like tax efficiency and low-cost investing; drawbacks include high bid/ask spread

What Are ETFs?

An ETF is a fund that owns underlying assets and divides ownership of these into shares. Assets can range across stocks shares, bonds, gold bars, forex and oil futures, to name just a few. The real investment vehicle structure for an ETF varies across the world, and multiple structures can exist together. It is important to understand that ETF explained thus does not assume shareholders directly own or claim the underlying fund assets. Rather, the ownership of these assets is indirect. ETF stockholders claim a proportion of profits, like dividends paid or earned interest. Only if the fund is liquidated will they get a residual value. Much like shares in the stock market, fund ownership can be sold, purchased or transferred, as ETF shares are also traded on public stock exchanges.

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ETF shares are regulated through creation and redemption mechanisms. The process involves certain large specialised investors called authorised participants or APs. These are essentially large financial institutions with greater buying powers, such as market makers like investment companies or banks.

How do ETFs work? Creation of redemption of ETF units takes place via APs. When creation occurs, an AP assembles the required underlying portfolio and hands over the basket to the fund, in return for freshly created ETF shares. For redemptions, it works like this. The AP returns ETF shares to the fund and accepts the basket comprising underlying portfolios. Another key feature of an ETF is that underlying holdings are publicly disclosed each day.

How ETFs Can Be Traded

ETF explained in terms of momentary arbitrage opportunities is a most cogent understanding of how this form of marketable securities works. To learn more about what are ETF, it is critical to understand the ETF and basket of underlying assets can be traded across the day. Arbitrage keeps ETF prices close to fair market value. For traders buying the ETF for less than underlying securities, the differential between ETF shares bought and underlying portfolio sold is locked in. Certain ETFs utilise gearing or leverage through derivative products for creating leverages or inverse ETFs. These ETF monitor the opposite return to that of underlying assets. For instance, inverse silver ETF would gain 3% for every 3% drop in the metal’s price.

On the other hand, a leveraged ETF works by gaining multiple returns to that of underlying assets. For a 2x silver ETF, a gain of 2% will take place for every 1% rise in the metal’s price. Leveraged inverse ETFs can offer both profits following inverse movements and leverage to gain multiple returns. Investors and markets alike benefit from the different types of ETF explained here. However, this form of trading in marketable securities is not without its pitfalls either.

Benefits of ETF Trading

  • Through ETF ownership and trading, investors can gain from the diversification of an index fund.
  • They also acquire the ability to sell short, buy on margin and purchase even as much as just a single share, as there are no deposit requirements of a minimum amount.
  • Moreover, expense ratios of ETFs are generally lower than that of average MFs. But, while purchasing or selling these funds, you have to pay regular commissions.
  • Favourable taxation on cash flows the ETF generates are yet another advantage.

What are ETF offering the trader? In a nutshell, capital gains from sales within the funds are not passed onto the shareholders, unlike an MF. There are a wide variety of ETFs. One example is the S&P 500 Index, Spider (called SPDR and trading under SPY). Some others include the IWM which tracks the Russell 2000 index and the TripleQ which tracks the NASDAQ-100 apart from the DIA tracking the industrial average at the Dow Jones.

Sectoral ETFs track individual industries, also abound, in fields like oil (OIH), financial services (XLF), biotech (BBH), REITs (IYR) and energy (XLE). Commodity ETFs track commodity prices such as crude oil or USO, gold or GLD, silver or SLV and natural gas or UNG. ETFs also track forex indices for developed and emerging economies and track global currency movements.

How Do ETFs Help in Meeting Investment Goals?

What are ETF, for an average individual investor? Exchange-traded funds are essentially an important and valuable vehicle to achieve investor goals. Buying and selling ETF, or baskets of securities via a brokerage on the stock exchange offers every conceivable choice. Offered on every asset class from conventional investments to alternative assets like currencies or commodities, innovative ETFs permit investors to short stock exchange markets, wield leverage and avoid short-term taxes on capital gains.

Since 1993, ETF trading has been rampant in developed countries like the US. The highest volume traded in ETF history is by the SPDR ETF. In American stock exchanges alone, close to USD 1 trillion is invested and nearly 1,000 ETF products are traded. While market ETFs are designed to track indices, bond ETFs provide exposure to every bond from corporate to municipal, international, government, and high yield.

Sector and industry ETFs are for traders specialising in a particular field. Apart from forex and commodity ETFs, there are also style ETFs which track market cap focus or investment style, like small-cap growth or large-cap value. Designed to track global markets, forex ETFs track indices like the Nikkei or the Hang Seng. Apart from inverse ETFs, there are also actively managed ETF to outperform the index. While exchange-traded notes are debt securities backed by creditworthy banks, alternative investment ETFs even permit investors to trade in volatility or gain exposure to a specific investment strategy.

How Are ETFs Traded?

So, how do ETFs work for a trader? An ETF is purchased and sold like a company stock during market hours, with its own ticker symbol and intra-day price data. The difference lies in the daily change in number of shares outstanding of an ETF on account of continuous creation as well as redemption of existing shares. ETF can issue and redeem shares on an ongoing basis, keeping market price of the funds in consonance with underlying securities.

While it is designed for an individual investor, the ETF’s liquidity is maintained and integrity tracked through the purchase and sale of creation units by institutional investors. Larger blocks of ETF shares can be exchanged for underlying securities. Whenever the price of the underlying asset and the ETF diverge, institutions use the arbitrage mechanism to ensure the prices converge.

Individual investors also benefit from the ETF. ETFs can be bought and sold any time of the day, while an MF settles only post-market closure. No sales loads for ETFs means lower fees. More tax efficient, ETF trading encompasses numerous types of orders, like limit, stop-loss, buy on and more, not possible with an MF. ETFs are passively managed and the expense ratio is lower because there are no costs like management fees, shareholder accounting charges at fund level or service and load fees.

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Trades Like a Stock

While ETFs offer diversification, they trade like stocks. These securities can be purchased on a margin and sold short. ETFs also permit risk management through trade of options and futures, much like a stock. ETFs come with their own benefits such as regular intra-day price updates. As these securities trade like stocks, investors can access the user-friendly interface of stock exchanges and get relevant information for manipulating charts, and apps for smartphones.

While the timing varies for index MFs, dividends for open-ended ETF are reinvested at once. Dividends in unit investment trust ETFs, on the other hand, may create a dividend drag. There are also lower chances of ETF prices that are lower or higher than the actual value. This is because ETFs trade based on demand-supply patterns. With close to 1,600 US ETFs in 2015, the popularity of these trading instruments is growing.

The first ETFs introduced were passively managed index. Today, investors can choose between fixed-income, index, actively managed, equity-based sectoral, leveraged or inverse ETFs. From small portfolios to large hedge funds, ETFs can help any class of trader meet market objectives. ETFs can contain multiple securities and come with bid and ask price. Investors can, therefore, control their trade timing and outperform the index. Building the best portfolio for investors requires planning. Exchange-traded funds offer numerous ways to invest in diversified funds at an affordable price. ETFs also offer low-cost indexing and a chance to invest in international diverse funds affordably.

All That Glitters is Not Gold!

  • ETFs have flaws, too.
  • If small amounts have to be invested frequently, a fund company’s direct trading in a no-load fund will offer better returns.
  • Thinly traded ETFs also have wide bid/ask spreads, which means the high price of the spread increases cost of buying and the low price lowers the sales price.
  • Finally, ETFs are not settled for 2 days post transactions, so reinvesting can be tough. Due to narrow stock groups in market indices, ETF investors may be limited to large-cap stocks. Long-term investors also have a horizon of a decade and intra-day pricing changes will not make any difference to them.

A high swing in just some hours could induce trades. Bias can, therefore, distort the investment objective. Niche ETFs result in low indexing and higher bid/ask spreads. If you compare dividend paying ETFs to high-profit stocks, risks associated may be lower for ETF owners, but so is the reward. ETFs track broader markets, resulting in average overall yield being lower.

The returns of leveraged ETFs can also be skewed and speculative investments like these must be cautiously assessed. Additionally, just because an ETF contains more than one underlying position does not mean it cannot be impacted by volatility. Being aware of the fund focus and investments it includes are important. International or global ETFs can also be impacted by currency fluctuations of the host nation. In some cases, ETFs may even distribute capital gains to shareholders.

Trading ETF’s

Low-cost investing has really caught on spurring ETF trading. Passive, and trading like stocks, these instruments are cheaper to run. Investments like these can ensure ETFs are part of a balanced portfolio. ETF investing needs to be all about understanding risk aversion and stock exposure. The level of assets of ETFs also indicate their staying power. It needs to generate a lot of interest to ensure funds remain operational. While selecting ETFs, traders need to focus on trading volume, assets and underlying index. With over 1,900 ETFs on US stock markets in 2016, alone, ETF trading is in vogue.

ETF markets are intensely competitive. Some issuers even work on niche ETF with specialised focus and short-lived investment trends. The broad diversification and low-cost features of the ETF derive from the index based structure. While ETFs have different goals in mind, from tracking the economy to diversifying portfolios, these marketable securities remain a great option for traders.

These versatile investment tools are ideal for long-term as well as short-term investors. Partial or fractional shares can even be purchased! ETF trading is hi-tech and diversified, preventing overexposure to any stock, bond or sector and lowering risk. Offering the best of both worlds, ETFs combine different investment assets, permitting far more agility and a greater degree of flexibility. Used effectively, trading ETFs can yield massive returns and power your investment portfolio.

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