Understanding Exchange-Traded Fund

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  1. What is Exchange-Traded Fund (ETFs)?
  2. Types of ETFs
  3. Advantages and Disadvantages of ETFs
  4. Actively managed ETFs
  5. How do ETFs work?
  6. How to invest in ETFs?

What is Exchange-Traded Fund (ETFs)?

ETFs are a form of exchange-traded investment vehicle that, under the 1940 Act, must be registered with the SEC as either an open-end investment corporation (often referred to as “funds”) or a unit investment trust.

ETFs, like mutual funds, allow investors to pool their money in a fund that invests in stocks, bonds, or other assets and, in exchange, earn an interest in that investment pool. ETF shares, unlike mutual funds, are traded on a national stock exchange at market prices that may or may not be the same as the net asset value (“NAV”) of the shares, which is the value of the ETF’s assets minus liabilities divided by the number of shares outstanding.

An ETF is a marketable investment, which means that its share price permits it to be purchased and sold on exchanges throughout the day, and it may be sold short. In the United States, most ETFs are structured as open-ended funds and are governed by the Investment Company Act of 1940, unless subsequent laws modify their regulatory requirements. The number of investors who can participate in an open-end fund is not limited.

Types of ETFs

1. Bond exchange-traded funds (ETFs)
These are typical ETFs that are meant to give exposure to various types of bonds. Bond investment is an excellent technique to smooth out the ups and downs of investing and diversifying a portfolio.

2. Currency exchange-traded funds (ETFs): These securities enable investors to engage in currency market transactions without acquiring a specific currency. The goal of these investments is to follow and profit from price movements in a certain currency or a basket of currencies.

3. Inverse ETFs: These products are meant to return the inverse of the underlying market index. The share price of these funds moves in the opposite direction of the share price of the inverse ETFs.

4. Liquid ETFs: These funds strive to reduce price risks and maximise returns by investing in a basket of short-term government assets with short maturities, such as money and money market instruments, while also striving to preserve liquidity.

5. Gold ETFs: These instruments allow investors to hold claims in the bullion market without having to acquire real gold. You might also buy ETFs that specialise in precious metals in general.

6. Index ETFs : They track the performance of their underlying index. They are further classified as replication ETFs and representational ETFs. Replication ETFs are index funds that invest solely in the equities underpinning the index.

Advantages and Disadvantages of ETFs

As it would be costly for an investor to acquire all of the equities contained in an ETF portfolio individually, ETFs provide reduced average costs. Investors just need to perform one transaction to purchase and one transaction to sell, resulting in lower broker commissions because investors only make a few trades. Brokers usually charge a fee for each deal. Some brokers even provide no-commission trading on select low-cost ETFs, significantly lowering investor costs.

The expense ratio of an ETF is the cost of operating and managing the fund. Because they mirror an index, ETFs often have low expenses. For example, if an ETF tracks the S& P 500 Index, it may comprise all 500 S& P equities, making it a passively managed fund that is less time-consuming. However, not all ETFs track an index passively and hence may have a higher cost ratio.

Pros — 1. Have access to a wide range of equities from various industries.

2. Reduced broker commissions and low expense ratios

3. Risk reduction through diversity

4. There are ETFs that specialise in certain sectors.

Cons — 1. Fees for actively managed ETFs are higher.

2. Diversification is limited by single-industry ETFs.

3. Transactions are hampered by a lack of liquidity.

Active Vs Passive Equity Funds

Actively managed ETFs

Also, there are actively managed ETFs, in which portfolio managers are much more concerned with buying and selling company shares and modifying the fund’s holdings. A more actively managed fund will often have a higher cost ratio than a passively managed ETF. To assess if an ETF is worth owning, investors should look at how the fund is managed, whether it is actively or passively managed, the resultant expense ratio, and the expenses vs. the rate of return.

How do ETFs work?

An ETF provider develops an ETF using a certain technique and offers shares of that fund to investors. The provider purchases and sells the ETF’s component securities. Even though investors do not own the underlying assets, they may be entitled to dividends, reinvestments, and other advantages.

How to invest in ETFs?

Because ETF shares move like stocks, individual investors often purchase and sell ETFs through a broker. Brokerage accounts enable investors to trade ETFs manually or using a passive method such as a robo-advisor. Investors who want a more hands-on approach must explore the expanding ETF market for funds to purchase, bearing in mind that some ETFs are meant for long-term investing and others are designed to be bought and sold over a short period of time.