An Exchange-Traded Fund (ETF) is a financial product that falls somewhere in between a fund and a share. On the one hand, it’s a fund, but on the other, you can trade it like a share. It can contain hundreds of different investments, but you only need to buy one thing. It can track an index without you having to buy every company in that index yourself. Broadly speaking, that’s the appeal.
An ETF is a fund that holds a collection of assets, like company shares, bonds, commodities or other securities. Investors can buy shares in the ETF, which then gives them exposure to the collection of assets held by the fund rather than having to purchase each investment individually.
The “exchange-traded” bit is what tells us how it works. ETFs are listed on stock exchanges and can generally be bought and sold throughout the trading day, with their market price moving as investors trade them.
So, rather than being one particular type of investment, an ETF is more like a container of sorts that can hold many different types of investments.
How does an ETF work?
Perhaps you want exposure to a particular stock market index. You could try to buy every company included in that index yourself, but depending on the index in question, that could mean buying hundreds of different shares, working out how much of each one to buy and then keeping everything balanced as the underlying index changes. A fairly complicated endeavour, to say the least.
Or, you could buy an ETF that tracks the index.聽The fund does the complicated bit for you聽鈥� it holds the underlying investments and aims to replicate the performance of the index that it follows. So, when you buy a share of the ETF, you’re basically buying a small piece of that portfolio.
Now, this is one reason ETFs are so useful for diversification. Instead of putting your money into one company, you can gain exposure to a much wider collection of companies through a single purchase, and you can do it in a fairly efficient way.
Of course, that doesn’t mean an ETF can’t lose money. If the market it tracks falls, the ETF will generally fall too. Thus, diversification simply means you’re not relying on one individual investment to determine the entire outcome, not that the risk is all gone.
What Can An ETF Invest In?
Most markets you can think of have the potential to have an ETF built around it. Some ETFs track broad stock market indices, while others focus on particular sectors, countries or regions. There are technology ETFs, healthcare ETFs, energy ETFs and emerging-market ETFs; there are ETFs that invest in bonds and others that provide exposure to commodities such as gold. There are also funds built around particular themes or investment strategies.
Safe to say, there are many different types of ETFs, so if somebody tells you they “invest in ETFs,” that doesn’t necessarily mean as much as you may think, because there’s a massive amount of potential variation.
An ETF tracking hundreds of companies across an entire market is one thing, and an ETF concentrated on a particular technology trend is something else entirely.
Passive Vs. Active ETFs
Most people talking about ETFs vaguely tend to associate ETFs with passive investing. Now, a passive ETF typically aims to track an index rather than trying to outperform it. If an ETF tracks a particular index, the fund will generally hold the relevant investments in a way that looks to mirror that index’s performance.
But, this is just one way of doing things; ETFs don’t have to be passive. Actively managed ETFs have investment managers that make decisions about which assets to buy and which ones to sell. Instead of simply following an index, the manager has a particular investment strategy and they attempt to achieve the fund’s objective through their decisions.
So, once again, “ETF” doesn’t tell you what strategy the fund uses. Rather, it tells you how the fund is structured and traded, and from there, you need to ask further questions.
What’s the Difference Between An ETF and a Mutual Fund?
ETFs and mutual funds are easy to confuse because they essentially start with the same idea: lots of investors put money into a fund, and then that is invested across a portfolio of assets.聽The big difference is what happens when you want to buy or sell.
An ETF trades on a stock exchange throughout the trading day, so its price can potentially change continuously as investors buy and sell. But a traditional mutual fund is generally bought and sold at its net asset value (NAV), which is normally calculated once at the end of the trading day. This means that an ETF’s market price can be slightly higher or lower than the value of the assets it holds. These are known as a premium or discount to NAV.
The difference here is more than just technical, as it forms part of explaining why an ETF behaves more like a share when you trade it.
Why Do People Use ETFs?
For many investors, the appeal of ETFs comes down to two main things: diversification and convenience. A single ETF can provide exposure to dozens or even hundreds of investments, and it can offer this while also making it easier to target a particular market, sector or investment theme. Thus, more benefits, less effort.
They can also be relatively cost-effective, particularly passive index-tracking ETFs, although it’s important to look beyond the ETF label. Investors should consider the fund’s expense ratio, trading costs and bid-ask spread, as well as whether the ETF uses more complex strategies.
So, what is an ETF really? It’s essentially a basket of investments that can be traded on a stock exchange. But what that basket contains can vary enormously. An ETF might track hundreds of companies, focus on one sector, invest in bonds or follow a highly specialised strategy.
That’s why the most useful question isn’t simply whether ETFs are a good investment; it’s what you’re actually buying. After all, two products can both be ETFs while carrying very different investments, costs and risks.
