What is ETF ? Exchange Traded Funds

What is ETF

ETF Stands for Exchange Traded Funds, An ETF is most often an exchange traded Index fund. An index fund is a type of mutual fund that is created to replicate the performance of a particular investment index like the S&P 500, the Russell 3000 or the Barclay’s Aggregate Bond Index.

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Index funds have much lower annual fees than classic mutual funds because they do not need to employ analysts or portfolio managers to replicate an index.

Index funds are typically traded once a day after the market closes and are valued at their net asset value (NAV, the total value of the underlying securities held by the index fund divided by the number of shares outstanding). An ETF is exchange traded which means it can be bought or sold at any time of the day during which the stock market is open. In other words the value of an ETF fluctuates throughout the day based on the underlying value of the index it tracks. Thus you could pay $60 per share at 11:00 am and $59.63 at 11:04 am if the ETF’s underlying index dropped in value by 0.6% in the intervening 4 minutes.

ETFs typically have lower management fees than their index fund cousins until you invest a minimum amount in the index fund. For example you typically need to invest at least $10,000 in a Vanguard index fund to get the same management fee as the comparable Vanguard ETF.

Because ETFs are exchange traded there is a risk that the price you realize upon sale or purchase might be different from the Net Asset Value depending on the amount of trading volume (liquidity) in that particular ETF.

ETFs have been created to track stock markets for a variety of countries, bond markets for a variety of countries, currencies, commodities and a wide variety of other indexes. In addition to index oriented ETFs (which represent the vast majority of the more than 1,400 ETFs issued to date), there also exist “exotic” ETFs which allow you to bet an index will decrease or add leverage to the returns of a particular index.

How do Exchange Traded Funds work?

Since Exchange Traded Funds directly invest in underlying assets or index, the risks and return are also linked directly to the performance of the underlying assets. Most importantly, ETFs are listed and traded like stocks and provide more flexibility, unlike traditional mutual funds. Their value changes on a real-time basis with the change in the underlying assets.

ETF offers individual investors the flexibility of buying and selling the units from a stock exchange in real-time basis unlike the closing day NAV for open-ended mutual funds.

Difference between ETF and Mutual Fund

Must read – Mutual Fund vs ETF

What are the types of Exchange Traded Funds or ETFs?

Gold ETFs: A Gold ETF is an Exchange Traded Fund that tracks the price movement of gold. An ETF that primarily invests in gold producing company or gold bullion are called as Gold ETFs. So, for a gold ETF, the share price must necessarily reflect the spot price of the underlying asset which is gold. This means the gold ETF’s performance will be dependent on the price movements of the gold in the market. Each ETF unit basically represents one gram of gold. For every unit of ETF issued the fund holds gold in the physical form of 99.5% purity. This fund is also allowed to invest in the gold deposits schemes of banks subject to a maximum of 20% of net assets of the scheme.

Most importantly, the custodian of the fund is responsible for the safeguarding of the assets. The actual returns from this gold ETF may be a little bit lower from that of the market return from the gold due to its expense ratio and cash holdings. The main benefit of this ETF is that investors are holding the equal value of golds not physically but on the paper basis and thus get rid of the risks of holding huge gold at home.

Commodity ETF: ETF that invests primarily in physical commodities such as natural resources, agricultural goods, and metals are called commodity ETFs. A commodity ETF can work in two ways such as either;

a) it may focus on a single commodity and holds it in physical storage or may invest in futures contracts. or

b) it forms an index that includes dozens of commodities with a combination of physical storage or futures contracts.

In recent times, the commodity ETFs have gained popularity due to the investors exposures to various commodities without the needs of learning various complex things regarding futures or derivative options.

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