Exchange-Traded Funds (ETFs)
ETFs are investment funds that trade on stock exchanges, similar to individual stocks. They pool investors’ money to invest in a portfolio of assets, such as equities or bonds, and can be bought or sold at the prevailing market price during the trading day.
Some of the most popular ETFs are passive tracker funds which aim to follow the value of a stock market index, e.g. the S&P 500 or FTSE 100. These mainstream funds typically have lower fees (expense ratios or ongoing charges). The diversity of the underlying index is important to risk management.
Other ETFs may target or track a particular market sector, or more specialised asset class including commodities (all of which will concentrate risk). Some ETFs are actively managed where a portfolio manager makes the investment decisions (rather than tracking an index).
ETFs may be structured as retail funds. For example, UK authorised funds are subject to detail regulatory requirements, including investment and borrowing powers and investor disclosure. They may have more simple investment objectives or a more complex investment and risk profile. Other Exchange Traded Products (ETPs) including Exchange Traded Commodities (ETCs) also operate on a pooled investment basis but are structured in the form of shares or debt instruments.
Physical ETCs buy and hold the commodity, e.g. gold. Synthetic ETF/ETCs use derivative instruments to access commodity markets such as energy, metals or livestock. This might be a contract for difference (CFD) on the spot price, or a futures derivative. They might have a market listing but there may be little or no market trading on the exchange.
The use of derivatives in an ETF enables other investment features. For example, Short/Inverse ETFs may seek to provide the opposite return to the underlying index or asset class. This would be equivalent to shorting the index or asset class. Leveraged ETFs buy (or sell) investment exposure on margin to significantly increase the volatility of risk and return.
Key Features of ETFs
Trading Flexibility
ETFs can be bought and sold throughout the trading day at market prices
Lower Costs
ETFs generally have lower expense ratios compared to mutual funds, especially those that are passively managed
Diversification
Like mutual funds, ETFs offer diversification by holding a basket of assets
Transparency
ETFs disclose their holdings daily, providing investors with up-to-date information
There are various types of ETFs
Index ETFs
Sector ETFs
Commodity ETFs
Bond ETFs
Both mutual funds and ETFs can be valuable tools for building a diversified investment portfolio. The choice between them often depends on factors like cost, trading flexibility, and investment strategy.
