Exchange Traded Funds (ETF)

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Exchange Traded Funds (ETF) Definition

An exchange traded fund (ETF) is a bundle of securities that replicate the performance of an underlying stock market index, commodity, sector, or assets. ETFs can be bought or sold over stock exchanges.

ETFs are very liquid, and their prices fluctuate during the market’s trading hours. ETFs are regulated by The Securities and Exchange Commission (SEC). SPDR S&P 500 (NYSE Arca|SPY), iShares Russell 1000 Index (NYSE Arca|IWB), and Vanguard S&P 500 (NYSE Arca|VOO are some examples.

Key Takeaways

  • An exchange traded fund (ETF) is a basket of stocks that traces the returns of an underlying asset, commodity, industry, sector, or market index.
  • ETFs are similar to the other stock trading since they are listed on stock exchanges for intraday buying and selling.
  •  The prices do not fluctuate much from their Net Asset Value (NAV)—they are less volatile than other stocks.
  • Due to low brokerage and commissions, the expense ratio of an ETF is lower than stocks.

Exchange Traded Fund Explained

ETF Full Form

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Exchange traded funds (ETFs) can be defined as a basket of stocks that reflect an underlying stock indexStock IndexThe stock index, which is also known as the stock market index, is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment investors use it to have knowledge about the performance of investments and access the total value they possess.read more like S&P 500. These stocks are traded on stock exchanges. It is suitable for investors who want exposure to specific industries.

ETFs also attract investors with a shorter horizon—to implement scalp tradingScalp TradingScalping refers to an intraday trading strategy in which traders seek to profit from small price swings in securities, currency pairs, and commodities over a short period. It requires them to enter and exit a trade in a matter of seconds, minutes, or hours in a single day.read more strategies. ETFs have an all-day trading window. The Securities and Exchange Commission (SEC) regulates ETFs. It can be managed both passively and actively.

The ETF’s trading value is based on the NAVNAVNet Asset Value (NAV) refers to the net value of an entity or equity obtained by subtracting the total value of its assets from the total value of its liabilities. It also indicates the per share or unit market value of securities like mutual funds, exchange-traded funds (ETFs), indexes, etc., on a given day.read more of the underlying stock. By doing so, it provides instant diversification—just like open-end funds. In addition, ETFs can be traded throughout the day—just like closed-end fundsClosed-end FundsA closed-end fund refers to a professionally managed fund whereby an investment company issues the initial public offering to raise capital. Later, these stocks are exchanged in the open market among the shareholders like other shares. Such investments provide better returns than the open-end funds.read more. Using the intraday facility, investors trade combinations of limit ordersLimit OrdersLimit order purchases or sells the security at the mentioned price or better. In the case of sell orders, it will be triggered at a limit price or higher, whereas for the buy orders, it will be triggered only at a limit price or lower.read more, stop orders, and short sellsShort SellsShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more. It is mandatory to disclose holdings twice a day; therefore, ETFs provide better visibility to investors.

Index FundsIndex FundsIndex Funds are passive funds that pool investments into selected securities.read more are similar, but limited diversification and little to zero alpha over-index keep long-term investors away.

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Types of ETFs

ETFs can be categorized into subtypes based on index, commodity, and sectors:

Exchange Traded Funds-(ETF)

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#1 – Fixed Income ETFs

Fixed income fundsFixed Income FundsFixed Income Funds are those mutual funds that invest in high quality fixed income securities like the government debt, treasury bill, money market and pay the investors a fixed rate of return as per the payment terms and period.read more invest in low-risk securities like bonds—to ensure constant and regular returns. It diversifies the portfolio. However, returns are quite low.

#2 – Real Estate ETFs

They are more volatile than fixed-income funds. Even so, they attract investors by providing ninety percent of the income to fund holders. It generates better returns by assuming slightly more volatility.

#3 – Equity ETFs

In Equity ETFs, the underlying benchmark is a stock or equity. It is further classified into large-cap or small-cap funds.

#4 – Commodity ETFs

Commodity ETFs replicate the returns of commodities—oil, gold, silver, etc. There is a negative correlationNegative CorrelationA negative correlation is an effective relationship between two variables in which the values of the dependent and independent variables move in opposite directions. For example, when an independent variable increases, the dependent variable decreases, and vice versa.read more between the US bond market and the commodity marketCommodity MarketThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities.read more. When the dollar value of bonds falls, there is an upward push observed in the commodity market.

#5 – Currency ETFs

Currency ETFs invest in the currency market—either in a single currency or a basket of currencies. Currency investments are undertaken to hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an assetread more foreign exchange risks. For example, having exposure to GBP may provide gains when Dollar depreciates in global markets.

#6 – Specialty ETFs

These ETFs are created to fulfill a specific purpose—foreign markets funds, derivative funds, inverse ETFsInverse ETFsAn inverse ETF is an exchange-traded fund (ETF) designed to generate returns when the value of the underlying asset or index falls. The product generally uses various financial derivatives, such as options and futures contracts, in their underlying constructs.read more and leveraged funds. They are not as liquid as conventional ETFs but are still held by corporates to hedge investment risksInvestment RisksInvestment risk is the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate. In addition, each type of investment is prone to some degree of investment or default risk.read more arising from operating in a specific market.

#7 – Sustainable ETFs

As the name suggests, these funds comprise sustainable investment options that emphasize environmental, social and governance factors.

Calculation

The Net Asset Value (NAV) of ETFs differs from a usual mutual fund—although both are calculated at the end of a trading day (typically at 4 PM). While mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more are bought or sold at NAV,  ETFs can be traded at various different prices—not just the NAV.

Thus, NAV calculations are essential for the following two purposes:

The following formula is used:

NAV=(Fund Assets-Fund Liabilities)/(Total Units Outstanding)

Example

Now let us look at an example to understand the calculation:

Consider an ETF that owns $5 billion in equities, $2 billion in bonds, and keeps $1 billion in cash. However, it owes $2 billion in management and exchange fees. There are 500 million outstanding units. Based on given values, determine the NAV.

Solution:

Calculation of NAV can be done as follows –

Exchange Traded Funds Example

NAV = [(5 + 2 + 1) – 2]/0.5 = $12

However, the fund may trade at different prices during the day—say at $11.97 or $12.02, depending on demand and supply. Efficient traders track anomalies and nullify these NAV differences quickly.  

Best Exchange traded Funds to Buy Now

The following list comprises promising ETFs for 2022:

  1. United States Natural Gas Fund LP (UNG)
  2. VanEck Oil Services ETF (OIH)
  3. SPDR S&P Metals & Mining ETF (XME)
  4. Simplify Interest Rate Hedge ETF (PFIX)
  5. iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)
  6. iShares MSCI Brazil ETF (EWZ)
  7. iShares Latin America 40 ETF (ILF) 

Advantages and Disadvantages

The pros of investing in exchange traded funds are as follows:

ETFs are prone to the following drawbacks:

Frequently Asked Questions (FAQs)

Is ETF a stock?

An ETF is not a single stock—but a bundle of securities. The bundle tracks an underlying asset, market index, sector, or commodity. However, these funds can be bought or sold over stock exchanges.

Do ETFs pay dividends?

ETFs allow full dividend payment—as allocated by the underlying stock or security. However, with most ETFs, dividends are automatically reinvested in the same fund—by allotting the additional units to the investors.

What’s the difference between an ETF and a mutual fund?

An ETF is a pooled investment product that can be traded over the stock exchange on an intraday basis. A mutual fund is registered on the stock exchange. Unlike an ETF, mutual funds cannot be purchased or sold on a stock exchange. Mutual funds are bought from respective fund houses.

Recommended Articles

This has been a guide to Exchange Traded Funds (ETF). We discuss exchange traded fund meaning, definition, & list of best high dividend ETFs using examples. You can learn more about asset management from the following articles –

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Comments

  1. Adeyemi Aanuoluwapo Felicia says

    Great lecture it has been.i hope to learn more on this platform

    • Dheeraj Vaidya says

      Thanks for your kind words!