Exchange-traded funds or ETFs have become a popular selection amongst investors aiming to broaden the variety of assets in their portfolios. This article explores ETFs, how they work, and the different types of ETFs available for investment.
An ETF, or an exchange-traded fund, resembles a mutual fund that is traded like a stock. ETFs can diversify an investor's portfolio without increasing the time - and also initiative - they need to spend managing and assigning their financial investments.
ETF Definition: What Does ETF Mean?
To specify what an ETF is, firstly, let's break down the term ETF. ET is an abbreviation of “exchange-traded”, which is to say that something is traded on the stock market. Some examples include Nasdaq or the New York Stock Exchange. For people used to trading individual stocks, buying and selling an ETF will certainly feel familiar due to the fact that it’s traded in much the same way.
In the abbreviation: ETF, ‘F’ stands for “fund”. One fund contains tens or even thousands of stocks or bonds. For investors familiar with a mutual fund, such as an index fund, trading an ETF will feel very similar, due to its diversity and low fees. ETFs often have lower costs than other types of funds, but this depends largely on the type, the risk and volatility of them, which can vary drastically.
What are ETFs?
An ETF or Exchange Traded Fund is a simple way for any investor to get exposure to a pool of bonds, stocks, or other assets without the need to acquire each of them separately. For example, when an investor buys stocks, they invest entirely into one company. When they buy a share of an ETF, on the other hand, investment is spread across various assets.
While the risk is significantly lower than investing in a single stock, ETFs still carry market risk. Since ETFs can imitate a market index like the S&P 500, their performance is normally based upon index volatility; when the index fluctuates in price, so does the price of the ETF.
Considering the impact of recent market volatility, especially during the pandemic, ETFs may not be the most stable investment at present.
How do ETFs work?
An ETF company will buy different types of assets like stocks, bonds, or cryptocurrencies to create a fund that would track their efficiency on the market. Then, a share of that fund is sold to shareholders, giving them exposure to all the assets that the ETF holds.
The value of the ETF varies over time and is correlated with the underlying assets that the fund owns. Each ETF has its unique ticker, with its value based on these assets. Traders buy and sell an ETF during the day on a particular exchange, in much the same way as stocks.
Constant production of new shares and the redemption of existing ones leads to a daily change in the total amount of shares of ETF. In this way, the ETF maintains the market price of the ETF correlated with the securities they own.
Types of ETFs
There are different kinds of ETFs available to investors. Just some of these include:
- Stock ETFs are intended to increase the chances of long-term growth. While generally less risky, in comparison to buying a specific stock, they still hold more risk than other types of ETFs. Usually, they offer diversified exposure to a specific industry trying to cover both well-established companies in the space and the new entrants that have a high potential for high growth and returns.
- Bond ETFs are usually used to create regular money inflow for the investor. They are obtained from the interest paid from the specific bonds within the fund. They may consist of government bonds, company bonds, as well as state or even local bonds. In addition, they don’t have a maturity date and are traded at a discounted price.
- Sector ETFs or Industry ETFs are focused on investments in a particular sector. It can be tech, financial health care, or the industrial sector, for example. Different industries perform better during an expansion period, while others during contraction periods. Overall, the most important thing is that the sector or industry that the fund is tied to is prosperous in the long term. This type of investing is highly volatile but an ETF combats that by gaining exposure to multiple companies.
- Commodity ETFs invest in raw goods such as gold and crude oil. Investing in commodity ETFs gives investors exposure to all these assets. However, exposure does not equate to ownership. For instance, even if an investor profits from the success of a particular ETF that deals in gold bullion, they can never redeem the gold bullion as their own, at any time. This means that while ETFs may be cheaper than purchasing the physical commodities of the ETF, investors are limited in their access to the physical commodity.
- Currency ETFs track the performance of different currency pairs - both domestic and foreign ones. Currency ETFs speculate on currency prices during certain political or economic conditions. They are also used as a hedge against market volatility since they are less volatile than other ETFs. For example, the Bitcoin ETF means that investors can gain crypto exposure, without owning Bitcoin themselves.
The Bottom Line
As with all investments, ETFs offer numerous options on the market to suit the investor’s needs, giving exposure to certain assets. For instance, Stock ETFs enable investors with lower risk tolerance, the ability to spread market risk across multiple companies with varying chances of success.
While ETFs may offer investors significant exposure to assets, they do not enable a direct form of investment into those assets. With precious metals, which can act as a safe haven for an investor’s portfolio, Gold or Silver ETFs present the issue that investors cannot redeem the precious metals being traded via the ETF. In the case of commodities like precious metals, ownership can be more important than exposure, in order to access the fullest extent of their benefits.