An ETF, or Exchange-Traded Fund, is a security that tracks an index, a commodity, or a basket of assets like stocks, bonds, or commodities.
ETFs can be bought and sold throughout the day on a stock exchange, just like individual stocks. It makes them attractive to investors because they offer the diversification of an index fund plus the flexibility and trade ability of a stock.
There are two main types of ETFs: passive and active. Passive ETFs track an index and try to match its performance. Active ETFs pursue a specific investment strategy, such as value investing or market timing.
How do ETFs work?
When you buy an ETF, you buy shares in a fund that holds an underlying asset or assets. For example, you can purchase shares in an ETF that tracks the Standard & Poor’s 500 indexes of stocks. To do this, the ETF buys all of the 500 stocks included in the S& P 500. It is very different from buying stock in a mutual fund because you are not purchasing individual securities — you are buying into a pool of other securities simultaneously.
Buying and selling ETFs works almost identically to trading individual stocks. When you sell your ETF, find its current price on your online brokerage platform and place a limit order with those parameters (i.e., $34.23 per share). A market order will fill at whatever price is available when your order is placed.
What are the benefits of ETFs?
- Diversification: ETFs offer instant diversification because they track an index or basket of assets. It means that you don’t have to invest in individual stocks to get exposure to a particular market segment. For example, if you want to invest in the technology sector, you can buy shares in an ETF that tracks the S& P 500 Technology Index.
- Low Fees: Passive ETFs usually have lower fees than actively managed mutual funds. In some cases, the prices for an ETF can be as low as 0.05 % compared to an actively managed mutual fund that charges 1.5%.
- Ease of Use: ETFs are usually sold in the same types of investment accounts that you buy individual stocks or other securities, including IRAs and 401(k)s. They are straightforward to trade because they are purchased and sold just like stocks throughout the day on stock exchanges.
- Transparency: It is straightforward for investors to see the security tracks underlying assets with an ETF. It makes it easier for investors to manage their portfolios because there are no surprises after a merger or spinoff occurs with an index component. ETF shares will be adjusted accordingly without affecting the value of your investment portfolio.
One basic ETF definition is a type of security that mirrors the movement of an underlying asset, such as an index, commodity or group of assets like stocks and bonds. ETFs trade on stock exchanges, making them more flexible than traditional mutual funds and easier to buy and sell.
ETFs offer several advantages
ETFs offer several advantages over other investment vehicles like mutual funds, including instant diversification, lower fees, transparency and ease of use. ETFs trade on stock exchanges just like stocks, making them more flexible and easier to buy and sell.
Passive ETFs track an index while active ETFs pursue specific investment strategies. Fees for ETFs are usually lower than those for actively managed mutual funds, and they are easy to use because they trade just like stocks. Lastly, investors have transparency into what the ETF is tracking. For these reasons and more, investors need to understand what ETFs are and how they work before investing in them.
Now you understand a little more about what ETFs are and how they work! As always, it’s essential to consult with a financial advisor before making any investment decisions. Thanks for reading!