Last editedMay 20212 min read
Are you looking for ways to invest your money? You might be interested in exchange traded funds, or ETFs. These blend the diversification potential of mutual funds with the ease of stock trading. Learn more about what an ETF is and how it works below.
What is an ETF?
The term ETF stands for exchange traded fund, which is a bundle of assets traded on an exchange. While mutual funds are priced at the conclusion of a trading day, you can buy and sell ETFs throughout the day the same way you would with an individual stock.
ETF trading is quite versatile. You’ll find ETFs at varying price points and risk levels, but they usually incur lower fees than other types of funds.
How does an ETF work?
The fund provider purchases a basket of underlying assets, like stocks, bonds, currencies, or commodities. They create a unique ticker for this basket, designing the ETF to track performance. The fund provider then sells shares in the fund to investors, who own a portion of the fund but not its underlying assets.
While an ETF tracks asset value, it will trade at market-determined prices that are separate to the asset itself. Buyers and sellers can trade the ETF on an exchange, just as they would with a stock.
Types of ETFs
When answering the question of what is an ETF, it’s also helpful to take a closer look at the various types of ETFs out there. There’s a high degree of variation dependent on the nature of underlying assets. Here are a few of the main types.
ETF stock investments include a basket of stocks, which makes them less risky than individual shares in a company. They’re best for long-term growth as you track the stocks over time.
If you’re looking for a lower-risk alternative to ETF stock investments, you could invest in a bond ETF. These don’t have a maturity date, unlike individual bonds. Investors benefit from regular interest payments generated by the individual bonds that underlie the fund.
Another option is to invest in ETFs based on underlying commodities like precious metals or coffee. This type of fund lets you bundle several securities into a single investment fund. Some will track the value of the physical commodities, while others will invest in companies that deal with the commodities or even futures contracts.
Pros and cons of ETF investment
As with any investment, there are pros and cons to ETF trading.
Advantages of ETF trading
One of the primary advantages is that ETFs let you diversify your investments across a broad range of industries and markets. Rather than purchasing all the individual stocks or commodities, you can invest in a pre-diversified fund.
ETF investments also offer the benefit of transparency, clearly traded on exchanges so that they’re easy to track. The fund’s holdings are displayed publicly on a day-to-day basis rather than quarterly as with other types of funds.
Disadvantages to ETF investment
However, you should also consider potential drawbacks of ETF trading, such as their associated fees. Because you’re trading these funds on an exchange, you might have to pay commission fees to a broker.
ETFs aren’t as liquid as some other types of assets. Although you can buy and sell throughout the day, if market prices are fluctuating, it might be more difficult to unload them. There’s also the danger that your ETF will suddenly close, forcing you to sell sooner than you would like at a potential loss.
Is ETF trading right for you?
ETF trading can be a good investment option if you’re already familiar with trading on the stock market. It gives an easy way to diversify your portfolio at lower risk than trading individual shares. If a single stock or bond performs poorly, ideally, others in the fund will be performing well to minimise loss.
To get the most out of your money, be sure you understand the ETF’s objectives, fees, and conditions. This will help you find the best fit.
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