Exchange-Traded Funds (ETFs) have become an increasingly popular investment vehicle in recent years, offering investors exposure to a broad range of markets and asset classes because they provide a low-cost, diversified investment option that can be easily traded on stock exchanges. This post aims to explain all the basics of ETFs that every investor should be familiar with.
Definition
ETFs are funds from investments that hold a portfolio of assets like bonds, stocks, commodities, or currencies. They can be traded on stock exchanges similar to individual stocks and are meant to monitor how well a particular benchmark or index performs. ETFs can be actively or passively managed and provide investors with instant diversification across different sectors, industries, and geographies.
What are the differences between ETFs and investment funds?
The key difference is how they are bought and sold. ETFs can be purchased and sold at any time throughout the trading day at market prices on stock exchanges, just like individual stocks. In contrast, Investment funds are bought and sold at the end of each trading day at the fund’s net asset value (NAV). This means that Investment funds can only be bought or sold at the end of the trading day, while ETFs can be traded throughout the day like individual stocks. They also typically have lower fees than Investment funds.
What is the difference between physical and synthetic ETFs?
The primary difference lies in how they monitor the performance of their underlying assets. Physical ETFs hold the actual securities or assets they are designed to track, such as stocks or bonds. The issuer buys and holds these assets in a custodian account on behalf of the fund, where the ETF’s value is based on the net asset value (NAV) of the underlying assets. On the other hand, synthetic ETFs use derivatives, such as swaps, to track the performance of the underlying assets. So, rather than holding the actual assets, the issuer enters into an agreement with a counterparty, usually an investment bank, to receive the return of the underlying assets in exchange for paying the return on a related financial instrument, such as a swap.
What are the advantages and disadvantages of investing in leveraged ETFs?
Leveraged ETFs use derivatives to amplify the returns of the underlying assets they track, which means that they can provide investors with higher returns, but they also come with higher risks. The disadvantages include higher fees, the potential for large losses, and tracking errors. Leveraged ETFs are best suited for experienced investors who have a high tolerance for risk and are willing to actively monitor their investments.
What is the process of creating and redeeming ETF shares?
The creation and redemption process is a unique feature of ETFs that allows authorised participants (APs) to create and redeem shares of the ETF in large blocks. When an AP creates a block of ETF shares, they receive a basket of securities that replicates the ETF’s underlying assets. This process helps to keep the ETF’s price in line with its net asset value (NAV). Understanding the creation and redemption process is important for investors because it can impact the liquidity and pricing of the ETF.
ETFs offer investors a low-cost, diversified investment option that can be easily traded on stock exchanges. They provide exposure to a broad range of markets and asset classes and can be actively or passively managed. Understanding the differences between ETFs and Investment funds, leveraged and physical ETFs, and the creation and redemption process is essential for investors to make informed investment decisions. And while they offer many benefits, investors should always carefully consider the risks and advantages of any investment before investing.
