What are Exchange Traded Funds (ETF’s)?
In simple terms an Exchange Traded Fund (ETF) is like a mutual fund, the only difference is that ETF can be traded on the stock market. An ETF is a fund which invests in an index, commodity, sector, theme or an asset. The value of these is based on the underlying asset that the it is invested in.
Lets say, that ABC ETF invests in the S&P 500. Here, the investors will pool their money and this money would be used to invest in the S&P 500. The fund would be divided into units and each investor would be allotted units based on the amount that they have invested in the fund. An ETF will be managed by a fund manager.
The price of the ETF keeps fluctuating. The reason for this is that ETF’s are traded on the stock market, meaning that the price of each unit is based on the demand and supply forces in the market. Lets say one unit of ABC ETF is trading at $10, a person might want to buy it for $11 and he bids for the same and a person who wants to sell his unit, sells it for that price, now the current price for one unit of that ETF would be $11.
ETF’s are less expensive when compared to mutual funds. This is because, they are traded directly on the stock market and this means that there is no middle man in the process. This saves up commission costs and expenses. They are also more liquid than mutual funds because an investor can buy or sell them anytime during the market hours. In some cases an ETF might be actively managed and this may have higher expenses when compared to the passive ones.
An ETF is a good way to diversify a portfolio. An ETF may hold many stocks or assets and in some cases it might just focus on one asset, for example a gold ETF only invests in gold.
There are chances of tracking errors in an ETF because it is traded on the stock market. For example, in the case of ABC ETF, the S&P 500 might go up by 5%, but the value of the ETF might go up only by 3%. Usually the difference is very less, but there might be some cases where the difference is high and this can lead to lower returns. This is one of the risks associated with an ETF.
ETF’s are regularly rebalanced based on the market conditions and changes. For example, a new company might be added to the S&P 500 and another would be excluded, this means that the fund managers would sell out the company that is now excluded and invest in the one which is newly added.
ETF’s may or may not pay dividends. They may instead choose to reinvest the dividends that they earn and help the fund grow.
An ETF is an amazing way to diversify ones portfolio and reduce the risks that it faces. Its also a good way to invest in case a person does not know much about the stock markets and analyzing about a company, as this is done by the fund managers. This also helps the investor in investing in a large number of stocks and earn good returns.
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