What is... | September 16, 2015

What is an exchange traded fund?

Investors who want to benefit from a basket of assets have several options they could try.

An exchange traded fund (ETF) is a type of financial product that has grabbed headlines since launching in the late 1980s.

Pick ‘n’ mix
ETFs are made up of assets such as commodities, bonds or shares. They may be based on one type of asset, or a mixture. ETFs are designed to track different financial market indices – following certain stock markets, or bonds, property, or commodities such as gold. As a result, they can be thought of as a special type of tracker fund, and can play a part in a passive investing strategy. One large ETF is the “Spider” (SPDR), created in 1993 to track the S&P 500 Index.

What’s different?
A wide range of ETFs is available. ETFs typically promise higher daily liquidity and lower fees than the shares of mutual or tracker funds, according to Investopedia. This is because they trade on the stock market like ordinary shares. The share price can change throughout the day, reflecting market movements. Mutual and tracker funds, on the other hand, are only priced at the close of each trading day.

For most people, this will make little long-term difference, but it is an option for those who want to trade an index more actively.

There is no minimum amount of ETF shares that must be bought to make an investment. Some investors believe ETFs can offer good value when managed well. Short selling, trading on margin (shares bought with borrowed money), and other speculative or active investing practices are possible with ETFs. While trackers and index funds typically hold many of the actual shares or bonds in an index, an ETF may use a variety of financial instruments to mimic the index tracked.

The downsides
There is no guarantee an ETF will give the same returns as the index being tracked – this is called “tracking error”. Increasingly, many ETFs are rather complex – so they are potentially hard to understand and assess for risk. ETF volatility and risk may vary, depending partly on what exactly is being traded. For example, an ETF tracking the US stock market will behave differently to one following gold prices. Some commentators have criticised ETFs as potentially expensive to trade as well as insufficiently diversified. Furthermore, being able to trade more often does not mean investors will get good returns.

Patience can be a virtue
In fact, research suggests that individual investors may do as well – or better – by adopting a simple “buy-and-hold” strategy focused on longer-term value. As always, prospective investors should consider the full costs, including fees and commissions, of any strategy carefully against any potential gains. There’s always some amount of risk when investing. However, if seeking to adopt a passive investing approach – rather than trying to actively play the market – an ETF might be an option.

You can read more about ETF pros and cons here.


eZonomics team
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