Exchange traded fund (ETF)
What is an ETF?
What is an ETF and how does it work? Looking for a simple ETF definition? We’ve got you covered.
What is an ETF?
What does “ETF” stand for? The ETF definition is as follows: an exchange-traded fund, also known as an ETF, is a fund designed to track a particular group of shares, bonds, commodities or other assets. The majority of ETFs, however, track an index, such as a bond index or a stock index like the S&P 500 or the Dow Jones Industrial Average.
Unlike mutual funds, you can trade ETFs on stock exchanges at any time during the trading session, rather than once at the end of the day. An ETF meaning is that of marketable security, which means that its price will change throughout the trading day.
ETFs may be an attractive investment as they offer stock-like features, tax efficiency and lower transaction and management costs.
Where have you heard about ETFs?
Today, ETFs are growing in popularity among investors all around the world. Many financial advisers typically suggest them as an alternative to mutual funds. If you read the financial press, you have probably seen many articles weighing up the pros and cons of investing in ETFs compared with mutual funds and whether it is the right time to include them in your investment portfolio.
What you need to know about ETFs...
An ETF is a type of fund that is based on various assets, such as stocks, bonds, commodities and others, and divides ownership of itself into shares that are held by shareholders. The details of the ETF structure usually vary by country or even region of a country.
The shareholders indirectly own the assets of the fund, and they will typically get an annual report. Shareholders are entitled to a share of the profits, such as dividends or interest, and they may get a residual value in case the fund is liquidated. Their ownership interest in the fund can easily be sold and bought.
Unlike traditional mutual funds, ETFs don’t redeem or sell their individual shares at NAV. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, known as creation units. The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimise the potential deviation between the market price and the NAV of ETF shares.
Investors can look up the price of ETFs by checking their tickers. For instance, an ETF that tracks the S&P 500 has the ticker symbol SPDR and is known as the Spider. The DIA tracks the Dow Jones Industrial Average.
ETFs can be useful for investors to spread risk as instead of buying shares in just one company, the investor gets a little piece of a bunch of companies. If they look at the overall spread of their portfolio and see they are missing a key element, they could go for an ETF to remedy this. For example, if they hold shares mostly in the UK or U.S. market, they might want to add an ETF covering the Far East or Europe.
Another advantage for investors is that they can be tax and cost-effective and provide diversification for a portfolio. While ETF fees can be as low as 0.2%, investors also have to pay brokerage fees. Some funds that target the more esoteric sectors or groups of stocks may charge more.
ETFs generally provide market exposure and diversification, transparency, low expense ratios, buying and selling flexibility and tax efficiency while still maintaining all the features of ordinary stock like short selling, limit orders and options.
Since ETFs can be economically acquired, held and disposed of, some investors choose to invest in ETF shares as a long-term investment for asset allocation purposes, while others frequently trade ETF shares to hedge risk over short periods or implement market timing investment strategies.