ETF Basics: What Is an Exchange-Traded Fund?
- What Is an ETF?
- How Does an ETF Work?
- ETFs and Diversification
- ETF Price and Net Asset Value
- Common Types of ETFs
- Potential Advantages of ETFs
- Important ETF Risks
- ETF Costs and Expenses
- ETF vs Individual Stock
- ETF vs Mutual Fund
- Questions to Consider Before Buying an ETF
- Key Takeaway
- Continue Learning
An exchange-traded fund, commonly called an ETF, is an investment fund designed to provide exposure to a group of securities, an index, a sector, a commodity or another underlying asset. ETFs are generally bought and sold on an exchange during market trading hours.
What Is an ETF?
An ETF is a type of investment vehicle that can hold a collection of underlying assets. Depending on the ETF, those assets may include stocks, bonds, commodities or other securities.
Instead of purchasing every underlying security individually, an investor may gain exposure to a broader collection through a single ETF. However, the level of diversification depends on the specific ETF and its holdings.
How Does an ETF Work?
ETF units trade on an exchange in a way that is generally similar to listed shares. During market hours, the market price of an ETF may change as buyers and sellers trade units.
The value of the ETF's underlying holdings can influence its overall value. Market supply and demand, liquidity and other factors may also affect the trading price.
A simple example
An index-tracking ETF may be designed to follow the performance of a specific market index. The ETF can hold securities associated with that index or use another permitted method to seek similar exposure.
ETFs and Diversification
One possible feature of an ETF is the ability to gain exposure to multiple securities through one investment. This can help reduce dependence on the performance of a single company, although it does not eliminate market risk.
A narrowly focused ETF may still carry significant concentration risk. For example, an ETF focused on one sector, country or theme may be more exposed to specific market events.
ETF Price and Net Asset Value
The market price of an ETF is the price at which units trade on an exchange. Net asset value, often called NAV, is generally based on the value of the fund's underlying assets after considering relevant liabilities.
Depending on market conditions, an ETF may trade close to, above or below its NAV.
Common Types of ETFs
- Broad market ETFs: Designed to provide exposure to a large group of companies or a broad market.
- Index ETFs: Designed to track or seek to track a specific market index.
- Sector ETFs: Focus on a particular industry or economic sector.
- Bond ETFs: Provide exposure to debt securities.
- Commodity-related ETFs: May provide exposure to commodities or commodity-linked instruments.
- International ETFs: May provide exposure to companies or markets outside an investor's home country.
Potential Advantages of ETFs
- Access to multiple underlying securities through one product.
- Ability to trade during exchange market hours.
- Availability of broad market and specialised investment options.
- Potential diversification depending on the ETF's holdings.
- Transparent information may be available about holdings, objectives and costs.
Important ETF Risks
- Market prices can rise or fall.
- An ETF may lose value.
- Sector or thematic ETFs may have concentration risk.
- International ETFs can involve currency, political and geographic risks.
- Trading costs, spreads and fund expenses can affect returns.
- An ETF may not perfectly match the performance of its benchmark.
ETF Costs and Expenses
ETFs can involve expenses and transaction-related costs. Investors may encounter brokerage charges, bid-ask spreads, fund expenses, taxes and other costs depending on the market and product.
Understanding total costs is important because expenses can affect long-term investment outcomes.
ETF vs Individual Stock
Buying an individual stock generally provides exposure to one company. An ETF may provide exposure to multiple securities, although the exact level of diversification depends on the fund's structure.
Both approaches involve risk. The appropriate choice depends on factors such as investment objectives, risk tolerance, time horizon and understanding of the investment.
ETF vs Mutual Fund
ETFs and mutual funds can both provide pooled investment exposure. However, their structure, trading method, pricing, costs and availability may differ.
Many ETFs trade on exchanges during market hours, while many traditional mutual funds are priced based on end-of-day NAV. Specific rules vary by jurisdiction and product.
Questions to Consider Before Buying an ETF
- What does the ETF invest in?
- What index or investment objective does it follow?
- How diversified are the underlying holdings?
- What are the fund expenses and trading costs?
- What risks are associated with the sector, country or asset class?
- How liquid is the ETF?
- Does the investment fit the intended time horizon and financial objective?
Key Takeaway
ETFs can provide access to different markets and groups of securities through a single investment product. However, every ETF has its own objective, holdings, costs and risks. Understanding the product before investing is an important part of responsible financial decision-making.