ETFs: What They Are and How They Work
An exchange-traded fund, commonly called an ETF, is an investment fund whose units or shares can generally be bought and sold through an exchange during market trading hours. ETFs can provide exposure to different investments, markets or investment strategies depending on their structure and objective.
What Is an ETF?
An ETF is a type of investment fund that pools money or represents exposure to a collection of underlying investments. Depending on the ETF, those investments may include shares, bonds, commodities or other assets.
The exact holdings and investment strategy depend on the specific ETF and its stated objective.
An ETF is an investment fund that can generally be traded on an exchange while providing exposure to one or more underlying investments or a defined investment strategy.
How Do ETFs Work?
Each ETF follows its own investment objective and methodology. Some ETFs may aim to track a market index, while others may follow different investment strategies.
Investors generally buy or sell ETF units through a market, and the market price of those units can change during trading hours.
An ETF designed to follow a broad market index may hold, or seek exposure to, investments represented by that index. The value of the ETF can rise or fall as the value of its underlying holdings changes.
ETFs and Diversification
Some ETFs provide exposure to many investments through a single fund. However, the level of diversification depends on the ETF's underlying holdings.
A narrowly focused ETF may still involve significant exposure to one sector, region, asset type or other concentrated area.
Market Price and Fund Value
The market price of an ETF is the price at which its units trade on an exchange. This may not always be exactly the same as the value of the ETF's underlying assets.
Differences can occur between the market trading price and the value associated with the underlying portfolio.
Potential Benefits of ETFs
- Access to different investment categories through a single product.
- Potential diversification depending on the underlying holdings.
- Exchange-based buying and selling during available market hours.
- Exposure to broad or specialised investment strategies.
- Transparency depending on the ETF's structure and disclosure practices.
Investment Risks
ETFs can lose value. The level of risk depends on the investments held, market conditions, concentration, liquidity and the ETF's specific strategy.
Holding multiple investments through an ETF does not guarantee protection against market losses.
Costs and Expenses
ETFs may involve management fees, operating expenses, brokerage costs, bid-ask spreads or other charges depending on how they are bought and held.
Understanding the total costs associated with an ETF can be important when evaluating its potential role within an investment portfolio.
ETFs and Index Funds
Some ETFs are designed to track market indexes, but not every ETF follows an index. Similarly, index-tracking funds can exist in different structures.
The investment objective, holdings, methodology, costs and trading features should be reviewed individually rather than assuming that all ETFs or all index funds work in the same way.
Questions to Consider
- What is the ETF's investment objective?
- What investments or assets does it hold?
- Is the ETF broadly diversified or narrowly focused?
- What fees and expenses apply?
- How liquid is the ETF?
- What investment risks are involved?
- How does the ETF fit within the overall portfolio?
Key Takeaways
- ETFs are investment funds that can generally be traded on an exchange.
- An ETF can provide exposure to one or multiple underlying investments.
- Some ETFs track indexes, while others follow different strategies.
- Diversification depends on the ETF's actual holdings and exposure.
- ETF market prices can change throughout the trading day.
- ETFs can involve fees, expenses and the risk of investment losses.