What is an ETF and how it works?

 

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Exchange-traded funds can be defined as the fund that trades on exchanges and is actively traded throughout the trading day. They offer real-time settlement and liquidity as they are listed on an exchange and traded like stocks. They also provide the benefits of lower risk and diversification, which often makes a fund safer to own than a stock. Due to the buying and selling of EFT the EFT share's price fluctuate all day and they offer fewer broker commissions and low expense ratio than buying the stocks individually. Therefore, ETFs are more liquid and cost-effective as compared to mutual funds. ETFs contain multiple assets or investments within, like bonds, stocks, commodities, and also mixture of investments, they can be considered a popular choice for diversification. An EFT is capable of owning stocks of one particular industry or sector to hundreds or thousands of stocks across various industries. These shares are traded throughout the day at prices that vary according to the demand and supply. A number of potential advantages are offered by ETFs investment, and some of them are-

1. Flexibility in trading- Mutual funds do not have the flexibility of being sold at real-time prices and throughout the day trading. The pricing of mutual funds is based on end of the day trading prices, where as ETFs are sold at real-time prices and traded throughout the day.

2. Expenses are low- In comparison to actively managed funds ETFs that are passively managed may have lower annual expenses.

3. Diversification-  An ETF can be a popular choice for diversification because there are multiple assets within an ETF, and they also contain many types of invesments, including, bonds, stocks, commodities, and a mixture of investment types.

4. No minimum Investment- An investor can purchase as few shares of EFTs as per his choice, where as most mutual funds require a minimum investment.

5. Efficiency in Tax- In the case of mutual funds the manager in order to pursue the fund's objectives, may trade stocks to satisfy the investor redemption. Taxable gains are created for the fund's manager due to sale of shares. On the other side redemption is not an issue because ETFs are like stocks.

Investments in ETFs may involve some drawbacks also-

1. Interference of Brokerage commissions- Due to brokerage commissions ETFs may be better suited for an investor who is buying large number of shares at one time and is planning to hold those shares for long-term.

2. Frequent trading may be encouraged due to trading flexibility- Frequent trading of ETFs may lead to moving stocks in and out at the wrong times in the market.

3. ETFs may lead to capital gain distribution- ETFs are responsible for distributing capital gains and dividends, distributed monthly or quarterly, depending on the ETF, therefore if there is no sale of any shares, one can face capital gain taxes. 

Types of ETFs- 

1. Stock ETFs- Stock ETFs can be defined as the collection of stocks which aims to provide diverse exposure to a single industry, one that includes new entrants with potential for growth and investors with high performing skills.

2. Bond ETFs- These bonds include corporate bonds, state and local bonds, and also government bonds. Regular income is provided to investors with bond ETFs and their income distribution is dependent on underlying bond's performance.

3. Active and Passive ETFs- Active ETFs have portfolio managers making decisions about which securities to include in the portfolio and do not target an index of securities. Active ETFs are more expensive for investors but have benefits over passive ETFs. On the other hand passive ETFs aims to replicate the performance of a targeted trend or sector or either a diversified index.

4. Commodity ETFs- Commodity ETFs, as the name suggests invest in commodities, including gold and crude oil. Holding shares in a commodity ETF is cheaper than physical position of the commodity, as it does not involve insurance and storage costs.

5. Industry ETFs- Theses types of industry or sector ETFs focuses on a specific industry or sector. The investor can focus on those companies performing well in a targeted industry or sector.

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