Exchange-Traded Funds (ETF) Definition
An exchange-traded fund (ETF) refers to the security type which contains different types of the securities in it such as bonds, stocks, commodities, etc that trades on the exchange like the stock and the price of which fluctuates many times in a day as and when the exchange-traded fund is bought and sold on exchange.
Explanation
It can be defined as a basket of stocks traded on the stock exchange reflecting the position of a stock index like the S&P 500 or BSE Sensex. The trading value of the same is based on the NAV of the underlying stock it represents. They bring in the best of both Open-end and Close-end funds. They provide instant diversification, just like Open-end funds, and can be traded throughout the day, just like closed-end funds. The advantage of all-day tradable funds is that investors can utilize combinations of Limit orders, stop orders, and even short sellShort SellShort 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 is allowed in some cases.
Example of Exchange-traded funds includes SPDR S&P 500 (NYSE Arca|SPY), iShares Russell 1000 Index (NYSE Arca|IWB), Vanguard S&P 500 (NYSE Arca|VOO), etc.
Types of Exchange Traded Funds (ETF)
Basis the underlying portfolio, Exchange-traded funds can be classified into six broad categories. types of exchange-traded funds are:
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For eg:
Source: Exchange Traded Funds (ETF) (wallstreetmojo.com)
#1 – Equity Funds
Equity funds can be further classified as Large Cap, Small Cap, etc., Sector-Specific funds, Index FundsIndex FundsIndex Funds is a form of mutual fund constructed to replicate and match the performance of a particular country's index like S&P, NASDAQ, etc., and helps investors take broad market exposure due to the amount invested in various stocks of the different sectors of the economy.read more, etc. As the name suggests, the underlying in these funds is equity. The investor gets the advantage of diversified investmentAdvantage Of Diversified InvestmentA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more with a small capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more rather than buying individual shares of each entity, which will cost more.
#2 – Fixed Income Funds
These funds offer lesser volatility, hence providing some degree of assured returns. The reduced volatility comes at the cost of lower returns. Typically, investors prefer to have 30 % to 40 % of their investments in 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. But this number may vary basis the risk profile of the investor.
#3 – Commodity Funds
While diversifying the investment, one crucial thing to consider is the Correlation between the instruments. Commodity funds provide just that. Historically it has been observed, and there is a negative correlation between the US equity/bond market and 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, i.e., when the dollar value of equity / fixed income instruments falls, there is an upward push observed in commodities like Gold, Silver, etc. The Commodity funds provide exposure to such items without actually buying individual units of high-priced commodities.
#4 – Currency Funds
One of the primary purposes of investing in currencies is to provide a hedge to exposure in local currency. For example, having exposure in GBP may provide gains when Dollar depreciates in global markets. Currency funds thereby provide a cheaper means to have such kind of exposure.
#5 – Real Estate Funds
These funds are more volatile than fixed-income funds. Still, they are more attractive as these funds are liable to provide ninety percent of the income to Fund holders, thereby generating better returns while assuming slightly more volatility.
#6 – Special Funds
Foreign Markets fund, Derivative funds, Inverse ETFs, leveraged funds are other complex structured funds which are sought by investors having specific requirements. Although a little less liquid then the conventional ETFs, these funds are held by Corporates to hedge exposure/ invest in markets specific to their business.
ETF NAV Calculations and Trading
Net Asset ValueNet Asset ValueNet Asset Value is calculated by subtracting the total value of the entity's liabilities from the total value of its assets and dividing the result by the total number of outstanding shares.read more of exchange-traded funds has a bit different interpretation from a usual Mutual Fund. Although, both are calculated at the end of a trading day (typically at 4 PM). The Mutual Funds are bought / Sold at NAV, whereas ETFs may trade at a different price than NAV. The trading price may be slightly different from the NAV. Still, NAV calculations are essential for the following two purposes:
- It gives an indicative direction of funds (whether it is Over or Underpriced).
- The Closing NAV can be used for Mark to market purpose.
NAV is calculated as:
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For eg:
Source: Exchange Traded Funds (ETF) (wallstreetmojo.com)
Consider an ETF Owns $5 billion in Equities, $2 billion in Bonds, and keep $1 billion in cash. It owes $2 billion in the form of management and exchange fees. Outstanding units be 500 Million.
Calculation of NAV can be done as follows –
- NAV = $ (5 + 2 + 1) – (2) / o.5
- NAV = $ 12
However, the price (which keeps on changing throughout the day) on the exchange maybe 11.97 / 12.02 depending on the forces of demand and supply. Such a difference from NAV is quickly nullified by the smart traders who keep track of such anomalies.
Advantages of Exchange Traded Fund (ETF)
The following are the advantage of the exchange-traded fund.
- Low Expense Ratio: Most of the ETFs are Passive funds i.e., these funds mimic the performance of indexes. This results in lower expense ratios i.e., lower fund management cost, sales, and distribution costsDistribution CostsDistribution cost is the total of all expenses incurred by the producer to make possible the delivery of the product from its location to the location of the end customer.read more.
- Taxes: Buy/ Sell transactions by ETF fund house are very few, as these are majorly passive funds. Hence, lesser transaction tax. Also, ETFs result in lower capital gains, therefore the lower capital gains taxes.
- Traded All Day: Exchange-traded funds are traded throughout the day, hence providing day trading opportunities for a scalp trader and bringing in all the possible combinations of Stop orders, limit orders, etc.
Disadvantages of Exchange Traded Fund (ETF)
The following are the disadvantage of the exchange-traded fund.
- Expensive: If diversification is not the priority, the cost of investing in ETFs will be noticeably higher than investing directly in stocks. As ETFs incur some management fees, howsoever small, they may be.
- Diversification: Although, investment is diversified when compared to cherry-picking the stocks to invest. ETFs are less diversified when compared to mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more.
- Taxes: The Capital gains are not uniformly low; certain funds have higher Capital gains tax because Treasury bonds transactions are subject to taxes. Also, to meet specific benchmarks, there may be more than the usual number of transactions, resulting in transaction taxes.
Important Points
Major points to be noted from previous sections:
- Although traded all day, price is close to NAV, unlike the closed-end fundsThe Closed-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.
- ETFs may have attached Call/ Put optionsPut OptionsPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more.
- ETFs are majorly passive managed funds, but increasing volume in financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more and rising competitions has led to the emergence of actively managed funds.
- ETFs have to disclose their holdings twice each day, thereby providing better visibility for investors.
- ETFs have a low internal expense ratio.
- ETFs are regulated by the Securities and Exchange Commission (SEC).
Conclusion
ETFs are used by investors who want exposure in specific sectors/ industries. They do have certain advantages over Mutual funds. They may be attractive for investors with a shorter horizon and implement scalp trading strategies because of an all-day trading window. The disadvantages like limited diversification and little to zero alpha over-index may keep long term investors away from the index funds. In the end, the decision about whether to invest in ETFs depends on what kind of exposure an investor is looking in.
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This has been a guide to what is Exchange Traded Funds and its definition. Here we discuss types of exchange-traded funds (ETFs) along with NAV Calculation, advantages, and disadvantages. You can learn more about accounting from the following articles –
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