An exchange-trade fund is a kind of investment fund and derivative product, i.e. they are traded directly on major stock exchanges like the New York Stock Exchange, NASDAQ and others. Like mutual funds, ETFs are purchased and sold during the day on various stock markets around the world, but with an added twist. While mutual funds can be purchased for a set price, ETFs can be purchased or sold at any time throughout the trading day.
What is an ETF? An exchange traded fund is just the same as any other mutual fund. Investors buy shares from the fund’s issuer, called an issuer, and in return they receive shares of the underlying stocks. These stocks are typically listed on various stock exchanges around the world and have been traded for years. Funds track the movement of individual stocks and in most cases follow the same method of choosing individual stocks as well as the same kinds of investments as other investors do. The difference between mutual funds and ETFs is that ETFs follow an almost automated methodology when it comes to selecting stocks and they don’t have to follow the same method as other investors.
Investors looking to buy ETFs should consider two things: liquidity and cost. In the world of finance and investing, the term “liquidity” means different things to different people. To some investors, liquidity refers to the ability of shares to trade freely on a securities exchange. To other investors, liquidity means a minimum number of shares for an investor to own. And finally, to many investors, cost is the key factor that leads them to buy or sell ETFs, rather than mutual funds.
As you probably know already, ETFs offer many advantages over stocks and bonds on a number of levels, including their expense ratio. An ETF does not incur any additional expenses on its behalf like a mutual fund, because it does not trade on a securities exchange. This means that there are no commissions or broker fees paid by investors who are purchasing ETFs, and ETFs typically have lower costs than stocks and bonds. Additionally, ETFs frequently carry less trading cost than mutual funds do.
One of the biggest differences between an ETF and a mutual fund is how they redeem their shares. With stocks and bonds, investors need to purchase additional shares at an auction, after paying brokerage and distribution charges. If there is insufficient demand for more shares, the auction may end without new ones being purchased, resulting in a loss for the investors. In contrast, with ETFs, most of the selling pressure occurs before the actual selling day. Since ETF shares are usually sold in block transactions, the supply and demand pressure result in an almost perfectly even price for each individual share, enabling investors to maximize the rate at which they sell.
Another advantage of an ETF over mutual funds is the diversity of investments that it allows investors to choose from. In contrast, most mutual funds focus only on one or two investment areas, making them very limited in what they can do. ETFs offer a wide range of assets, including metals, foreign currency, and more, giving investors a much wider range of opportunities. Investors who like to invest in a variety of different areas may find an ETF a better fit for them.
Some may question whether an ETF is really a “self-directed” fund. Self directed funds are usually less stable and have higher risks, since they are not subject to the same financial regulations as traditional funds. However, since ETF shares are sold in blocks, this is not an issue. This also makes ETFs ideal for high-risk investors who don’t want to have to give up control over their portfolio. Even if the risk factor doesn’t seem high at first, with a little experience investors can learn to manage their portfolio and improve its performance.
An ETF does have a disadvantage, however. Since an ETF is not actually connected to the shares of the underlying stock, ETFs typically follow the movements of the price of the underlying stocks. This can mean that an ETF can lag behind the movement of the stocks it is linked to, resulting in large losses for an investor. To prevent this problem, when an ETF starts to show performance after it has bought and sold all of its stocks, it must follow the same path as the stocks it bought, or it will suffer a loss.