Exchange-Traded Funds (ETFs): Explanation, Importance, And Pros & Cons 

January 19, 2024


ETFs (Exchange-Traded Funds) are a type of investment funds. However, these funds offer the benefits of two types of assets. They offer the diversification of mutual funds and the trading ease of stocks. In general, an ETF consists of a basket of investments, including stocks, bonds, etc. Furthermore, in comparison to other funds, ETFs are mostly lower in price. Additionally, you can also invest in many assets at once by investing in an ETF.

In this article, you will learn about exchange-traded funds in general and how they work as a form of investment. Furthermore, we will also discuss the major types of exchange-traded funds. Finally, we will share tips on how to choose exchange-traded funds with you, along with the necessary pros and cons. Hence, to learn more, read on through to the end of the article.

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What Are ETFs (Exchange-Traded Funds)?

What Are ETFs (Exchange-Traded Funds)

According to the Forbes Advisor,

ETFs, as the name suggests, are funds that are traded directly on the exchange and hence called exchange-traded funds. These are generally index-based products that do not require active management. An ETF tracks an index of the asset as closely as possible to generate returns akin to the basket. In fact, the trading price of an ETF is linked to the net asset value (NAV) of the underlying asset that it represents.” 

In general, an ETF (exchange-traded fund) is a pooled investment security and works quite similarly to a mutual fund. Basically, an ETF will track a particular index, commodity, sector, or asset. However, unlike mutual funds, you can purchase or sell an ETF in a stock exchange like a regular stock.  

One can structure an ETF to track a lot of things. This can include the price of an individual commodity or even a large and diverse collection of securities. Furthermore, you can also structure an ETF to track specific investment strategies. 

Do you know? – The SPDR S&P 500 ETF (SPY) is the first ETF. It tracks the S&P 500 Index and is an active ETF even today. 

An ETF can consist of all types of investments, namely stocks, bonds, and commodities. Also, the share prices of ETFs fluctuate throughout the day, and it depends on the buying and selling of the ETFs. This is where ETFs differ from mutual funds, as the latter trade only once a day after the market closes. Moreover, ETFs are also cost-effective and more liquid as compared to mutual funds. 

How Do ETFs (Exchange-Traded Funds) Work? 

How Do ETFs (Exchange-Traded Funds) Work

According to Investopedia,

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification. ETFs can thus contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types.” 

Just like stocks, ETFs are traded on an exchange. With the buying and selling of stocks on the market, the price of an ETF will change throughout the day. This is not the case with mutual funds, as these funds trade only once a day after the closing of the market. Hence, the latter’s cost is more or less stable. 

An ETF can consist of hundreds or thousands of stocks across various industries. Apart from that, one can isolate an ETF to one particular industry, too. While some funds focus only on US offerings, others tend to focus globally. For instance, ETFs that are focused on banks contain bank stocks across the world. 

Another interesting aspect of ETFs is that they are marketable security. This means that the share price of ETFs allows them to purchase and sell easily in the market throughout the day. In the US, you will find ETFs as open-ended funds. This is as per the provisions of the Investment Company Act 1940. In general, the number of investors in open-end funds is unlimited. 

Cost Of ETFs

When it comes to cost, the price of ETFs can significantly vary. However, the median price for an ETF, as per trading volume, is near $60. However, the trading volume can vary a lot. In some cases, it can go as high as $450 and can be as low as $4 or less. 

What Do ETFs Consist Of?

You can get exposure to a basket of securities, bonds, or commodities on an exchange like a stock. However, the basic character of ETFs is the same as that of mutual funds. On the other hand, ETFs also have similar features to equity shares.

The structure of an ETF is almost the same as the unit creation of a mutual fund. Here, you can buy or sell the units directly in any exchange trading platform during market hours. To ensure that the price remains close to the NAV, ETF trading is done on the exchange. The difference in the value of the return of the ETF and the value of the index is called tracking error. 

Generally, with ETFs’ help, investors can invest in a fund that performs like a basket of securities. Also, an investor can buy or sell units of this fund on the exchange. Here, the willing buyer and seller determine the price of the ETF. Hence, during trading hours, an ETF price keeps changing based on price changes in the underlying securities. 

Apart from providing adequate liquidity to investors, ETFs also offer a fair price. Apart from that, there are also designated brokers (also known as market makers) who offer a two-way quote for both buying and selling. They ensure liquidity as well as fair prices so that the prices remain near NAV and there is no big margin between the two. 

What Are The Types Of ETFs (Exchange-Traded Funds)?

What Are The Types Of ETFs (Exchange-Traded Funds)

NerdWallet explains,

Exchange traded funds may trade like stocks, but under the hood they more resemble mutual funds and index funds, which can vary greatly in terms of their underlying assets and investment goals. Below are a few common types of ETFs — just note that these categories aren’t mutually exclusive. For example, a stock ETF might also be index-based, and vice versa.” 

There are different types of ETFs that an investor can use for speculation, income generation, etc. Based on the types of held investments, the following are the major types of ETFs: 

Passive And Active ETFs 

Active and passive ETFs depend on the type of management. A passive ETF tries to replicate the performance of a broad index. This can include a diversified index, a specific trend, or a sector. For example, in the gold mining sector, there are nine ETFs in various gold mining companies.  

However, ETFs subject to active management do not target a security index. Rather, these come with portfolio managers to make decisions about what types of securities will be in the portfolio. As compared to passive ETFs, these funds are more beneficial. However, they are expensive to investors at the same time. 

Bond ETFs

Bond ETFs help in providing regular income to investors. The income of the investors depends on the underlying bond’s performance. These also include corporate, government, and state and local (municipal) bonds. Furthermore, there is no maturity date for a bond ETF. Also, in most cases, they trade at a premium or a high-discount price. 

Stock ETFs

These include a basket of stocks from a single sector/industry, for example, an automotive or foreign stock. Here, the target is to provide diverse exposure to a single industry. An industry containing high performers and new entrants is attractive to investors. Furthermore, stock ETFs also have lower fees, as compared to stock mutual funds. Also, these funds do not involve actual security ownership. 

Commodity ETFs

These ETFs invest in commodities including gold and crude oil. Such ETFs provide a variety of benefits to investors. One of the major benefits is that it helps investors to diversify their portfolios. Hence, it gets easier for investors to deal with downturns. On the other hand, it is also cheaper to hold shares in commodity ETFs. This is because a commodity ETF does not include storage costs and insurance. 

Sector ETFs

According to NerdWallet,

Sector ETFs provide a way to invest in specific companies within those sectors, such as the health care, financial or industrial sectors. These can be especially useful to investors tracking business cycles, as some sectors tend to perform better during expansion periods, others better during contraction periods. Often, these typically carry higher risk than broad-market ETFs.” 

In the United States, there are eleven sectors in the stock market. Each one of them is made up of companies that work primarily in the given sector. By choosing a sector ETF, you will be able to mold your portfolio based on the industry that intrigues you the best. This is also less risky than investing most of your capital in a single company. 

Currency ETFs

Currency ETF tracks the performance of currency pairs and consists of both domestic and foreign currencies. Apart from that, these exchange-traded funds also serve other purposes too. As an investor, you can use a currency ETF to speculate prices of other currencies due to politico-economic developments throughout the world. 

Investors also use currency ETFs to diversify their portfolios or use them as a hedge against volatility in forex markets. These ETFs also help in hedging against rising inflation. 

Bitcoin ETFs

It is also a type of currency ETF, and the United States Securities and Exchange Commission approved it this year. However, the SEC is still skeptical about the risks of Bitcoin ETFs. Despite that, these ETFs bring some regulatory safeguards, which make it easier to enter the crypto market. 

Investopedia says,

They expose investors to bitcoin’s price moves in their regular brokerage accounts. It invests directly in bitcoins as the underlying asset. Bitcoin futures ETFs, approved in 2021, expose investors to crypto without needing to own the coins. They use futures contracts traded on the Chicago Mercantile Exchange and mimic the price movements of bitcoin.” 

Inverse ETFs

In this case, the aim is to earn gains by shorting stocks from stock declines. Shorting is when an investor sells a stock by expecting a decline in value and repurchasing the stock at a lower price. To shorten stock, Inverse ETFs use derivatives. When there is a decline in the market, the inverse ETF increases proportionately.

However, before you invest in an inverse ETF, make sure to check with your broker to find out whether it is a good fit or not. This is because many inverse ETFs are simply exchange-traded notes and are not true ETFs.

Leveraged ETFs

These are exchange-traded funds that track an existing stock index. However, they do not match the returns of the index and try to increase them by two to three times. To leverage returns, these ETFs make use of derivatives that include options or futures contracts. 

Major Pros And Cons Of ETFs (Exchange-Traded Funds)

The following are some of the major pros and cons of exchange-traded funds that you need to learn: 

Pros Of Exchange-Traded Funds

Here are the major pros of exchange-traded funds that you will benefit from: 

  • You will have access to a variety of stocks across different industries in the United States. 
  • The ratios are of low expense, and you will not have to pay a lot of commissions to brokers. 
  • Since there is diversification, there are better options for risk management. 
  • There are also certain ETFs that focus on targeted industries. 

Cons Of ETFs

Here are a few cons of exchange-traded funds that you must be aware of: 

  • Active ETFs (actively managed) are available for higher fees. 
  • There is limited diversity in ETFs that are focused on a single industry. 
  • ETFs face a lack of liquidity sometimes. This further hinders transactions.

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Wrapping Up

Hope this article was helpful for you in learning about exchange-traded funds or ETFs. If you want to gain exposure to a broad variety of securities on a limited budget, then ETFs can be a cost-effective option for you. However, before you invest in any ETF, make sure you take advice from a financial advisor. 

Do you have more information on how ETFs work? Consider sharing your views with us in the comments section below.

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Soumava Goswami

A passionate writer and an avid reader, Soumava is academically inclined and loves writing on topics requiring deep research. Having 3+ years of experience, Soumava also loves writing blogs in other domains, including digital marketing, business, technology, travel, and sports.

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