What is an ETF and What You Need to Know When Investing

What is an ETF and What You Need to Know When Investing

The world of investing, trading and stocks can be a minefield to navigate, especially if you’re taking your first steps into the realm of investment.

In addition to the scathes of investment-centric jargon all new investors have to get to grips with, there are many different types of investments to choose from, with one popular type of investment being the Exchange Traded Fund, more commonly referred to as an ETF.

What is an Exchange Traded Fund?

Simply put, an Exchange Traded Fund (ETF) is a collection of trading securities – which can be stocks, bonds, commodities, or a combination of these investment types – which typically track a particular index, industry or sector.

The vast majority of ETFs are passively managed, which means they track – and aim to match – the performance of an underlying index, sector or industry.

Although Exchange Traded Funds are like mutual funds in the sense that the fund comprises a diverse portfolio of different investments, ETFs have the benefit of being able to be traded like a regular stock. 

So, ETFs can be bought or sold and traded for profit throughout the day, just like stocks on the stock exchange, and the price of an ETF will, likewise, fluctuate throughout the day. ETFs are therefore unlike mutual funds because they can only be sold at the close of the market – usually at the end of the day.

As a type of marketable security, an ETF has an associated price. However, when buying and selling ETFs, there are two prices you need to be aware of: the asking price and the bid price, the former being the price for which you can purchase an ETF and the latter referring to the price for which you can sell the ETF.

What are the benefits of investing in ETFs?

Exchange-Traded Funds are made up of multiple securities that represent shares in numerous companies, commodities or industries, allowing ETF owners to enjoy the benefits of a diverse portfolio of investments – such as risk offsetting and the likelihood of seeing steady returns over time – without the exorbitant costs of buying these stocks individually.

For example, an ETF tracking an index such as the S&P 500 might contain all 500 stocks from the index – through ETFs can contain potentially thousands of stocks – only one purchase needs to be made to acquire this selection of stocks.

More than this, with individual stocks, a broker’s fee is usually paid each time a stock is bought and sold, making it more costly to trade multiple separate stocks. On the other hand, Exchange Traded Funds are considered one stock in that they are traded as one unit, and therefore only one broker’s fee is applied each time an ETF is bought and sold, making ETFs a less costly option than mutual funds.

How are ETFs made?

ETF providers work with Authorized Participants, often financial entities such as investment banks, to create new shares of their particular Exchange Traded Fund. 

When an ETF provider wants more shares to be available, the Authorized Participant buys the underlying securities that make up the ETF shares in the correct proportions for the fund and delivers these to the ETF provider. The provider then gives the AP the same value of ETF shares in exchange – this is known as a ‘creation unit’ and typically comprises 50,000 shares.

It’s important to note that, while the AP is given the same value in ETF shares – in terms of the fund’s Net Asset Value – this is not necessarily the same price that the ETF will be trading for on the market, allowing the AP to resell the ETF shares at a profit.

Moreover, the mechanism also works in reverse. Authorized Participants can remove ETF shares from the market – enough to form a creation unit – and return these to the ETF provider for the individual securities that make up the ETF.

This process, known as the creation and redemption mechanism, helps to ensure that the ETF share prices don’t veer too far away from the value of the securities that make it up.

Where should you start with ETF investing?

Like purchasing traditional stocks, ETFs can be bought and sold on most online investing platforms and apps, often free to use.

Next, you’ll need to research the different types of ETF to decide which class to invest in as there are tons of different kinds on the market, including Bond ETFs, Stock ETFs, Industry ETFs and more.

Depending on what type of Exchange Traded Fund you purchase, you will need to research the whole sector, industry or index that the shares within your ETF belong to, and, like with any investment, you should consider which trading strategy to employ when buying and selling your chosen ETFs, whether you’re thinking of dollar-cost averaging or swing trading.

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