What Is an ETF?

If you’re into stock trading, you’ve probably heard of one particular acronym – the ETF, or exchange-traded fund. ETFs have become extremely popular over the last five years or so because they give you the flexibility and profit potential of stocks with the benefits of an investment fund, all rolled conveniently into one tidy package.

Here, I’ll explain what ETFs are, their benefits, and how to find them.

ETFs Explained

As I mentioned above, an ETF stands for exchange-traded fund. That pretty much is exactly what it is: a fund of stocks that you can trade on an exchange just like a regular stock.

Before I get into the specifics of an ETF, I’ll cover the idea of a fund. A fund – or investment fund – is a pool of securities that are bundled together. It’s a collection of assets that usually is managed by an investment manager or fund manager who makes investment decisions for the fund. The idea is to share costs, diversify (and reduce risk), and get a better return by having a professional manage the assets.

A fund can be open-end or closed-end. The basic difference between the two is how they’re structured. Open-end funds issue shares based off the net asset value, or NAV (the total value of the assets in the fund minus its liabilities).

There’s no limit to the number of shares issued by an open-end fund, and the value of these shares is determined only by the NAV of the assets in the fund. In other words, the value of the shares you buy with this fund isn’t affected by how many other people in the market want that share.

A closed-end fund is different. There are only a set number of shares issued, and these are traded actively on an exchange. The value goes up and down based off demand for the shares, just like a stock.

Traders who trade these are looking to buy shares at a discount, or when the price is lower than the NAV of the fund. The hope is that the difference between the discount price and the NAV will shrink – resulting in profits.

An ETF combines features of both types of investment funds into one package. The price of an ETF goes up or down based on demand during the course of a trading day just like a closed-end fund, but the ETF is also valued based on its NAV like an open-end fund.

Types of ETFs

There are several types of ETFs on the market. The most common types are:

  • Index ETFs: These ETFs try to track the performance of a stock market index. For example, the value of an index ETF positively tied to the S&P 500 Index goes up if the S&P 500 goes up.
  • Commodity ETFs: These ETFs are tied to a particular commodity, like gold, oil, or natural gas. These indices don’t actually invest in securities, but in some other way of replicating the value of whatever commodity they’re following. If the price of gold rises, for example, an ETF like SPDR Gold Shares increases in value. (This particular ETF possesses more gold than the government of China!)
  • Currency ETFs: This type of ETF tracks foreign currency, or forex.
  • Leveraged ETFs: These ETFs are unique in that they are leveraged, or, are far more sensitive to movements in the market than other ETFs. For example, the ProShares Ultra S&P 500 Fund tracks the S&P 500 Index and gives returns equal to twice the performance of the S&P 500. These can generate greater profits but greater losses as well.

These days, you can find just about any kind of ETF for any purpose. There are over 1,000 ETFs on the market, and new ones are added virtually every quarter.

Benefits of an ETF

Why are ETFs so popular?

ETFs have several advantages over other types of tradable assets. One of the biggest benefits is cost. ETFs have lower expense ratios (total percentage of the fund’s assets used for overhead and operating expenses) than mutual funds, for example. Many brokerages also offer low-cost or free ETF trading, especially if you trade their proprietary ETFs. Mutual funds typically have other trading fees that aren’t associated with an ETF.

ETFs are also very tax efficient. That’s one of the main reasons they were created in the first place. You gain the benefits of a mutual fund without having to pay capital gains taxes on the profits that the mutual fund generates.

You only pay taxes on the profits you make by selling your shares. In certain parts of the world – like the United Kingdom – you can actually shield yourself from taxes incurred form ETFs by putting them into your Individual Savings Account, or even a personal pension.

Finally, since you can actively trade an ETF, you don’t have to let your money just sit in an account like you do with a mutual fund. You can use them for long-term and short-term investments.

If you think the tech industry as a whole is going to get a nice boost when quarterly reports are released next week, you can get an ETF to reflect that. Or, if you think the price of gold is going to spike because the European Union or United States are going to take on more debt, you can get in on a gold ETF.

Where to Find ETFs

ETFs used to be tricky to find, but now they’re widespread. There are many ETF lists out there, and stock pickers can help you pinpoint the right kind of ETF for you. Plus – and this is a pretty nice bonus –many brokerages have their own ETFs they’ll let you trade for free or at a steep discount.

As with anything, research the market and find the right ETF to match your risk profile and your needs. With over 1,000 to choose from, you’ll definitely find an ETF that works for you.

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