What Is An ETF And How Does It Work?

  • An Exchange Traded Fund (ETF) is a collection of assets that can be bought and sold on an exchange
  • Most often, the assets of funds are stocks or bonds
  • With ETFs, private investors can diversify their portfolio without too many problems
  • ETF shares can be traded on foreign exchanges

How An ETF Works – Explained Simply

ETF explained: ETF (Exchange-Traded Fund) is a security that certifies the ownership of a certain part of a specific portfolio of securities.

how to trade ETFs

For an ETF to exist, several different types of financial companies are needed to ensure that the ETF’s price and its underlying asset are matched and that ETF’s shares are properly offered on the market and repurchased when investors want to sell their stakes in the fund. The fund manager is responsible for all this.

In theory, all a fund manager needs to do is think over and describe in detail the composition of the ETF (which rarely changes) for other investment firms that will participate in the creation and redemption of the units of this fund. In practice, of course, only the largest institutional investors, with a huge amount of capital and experience in creating index portfolios, are able to fulfill this function.

ETF creation officially begins with the selection of a professional market participant called a market maker or specialist. After a thorough assessment of the competence and reputation of a given participant, he or she is entrusted with a stock of securities and money placed in a special bank and depository. This is necessary for a given trader to always provide the necessary supply of securities on the market, no matter how many clients want to buy or sell at the same time. The special depository also controls that all ETF shares sold by the market maker are fully backed by assets in the manager’s account, which will ensure that clients’ income from the growth in the value of the fund.

As a rule, the securities that secured the fund are simply invariably kept in the depository, periodically, only the volume of the portfolio changes without changing its structure. The manager only occasionally receives dividends, which are paid on the shares included in the index, and distributes them to the ETF holders. Some managers use derivatives to provide a simpler and more accurate match to the index.

ETF Compared To Stocks

ETF is an exchange-traded fund. The fund includes, as a rule, not one share or not only shares but also other instruments (for example, bonds). In its turn, a stock is linked to the assets of one company, and an ETF is linked to the assets of many companies. If the company, whose shares you own, suffers, you will incur a proportional loss. If one company, which is part of the ETF, suffers, you will either hardly experience a loss, or you will be in the black (since other companies that are part of the ETF could have risen in price).

Thus, ETF, like stocks, is traded on the stock exchange, but unlike a stock, it is a highly diversified instrument. This is both a plus and a minus (no matter how strange it may seem). If you don’t want to “bother” studying reliability and profitability (as well as risks), ETFs are a great tool. If you want above-average returns, you have to choose stocks over ETFs.

Another difference is commission fees. Given that the ETF is a fund, it is obvious that someone is managing it. And they don’t do it for free. Get ready to pay a commission to the manager for a certain period. The size of the commission may vary.

ETF Compared To Mutual Funds

exchange traded funds explainedMutual funds and ETFs have one thing in common – they are collective investment instruments. However, ETFs bypass mutual funds in many ways.

Exchange-traded funds and investment funds are united by the fact that they are instruments of collective financial investments. This option implies that investors’ funds are located in a single investment portfolio and are invested in certain financial instruments, which can be bonds, stocks, etc.

The management company is responsible for the assets of such funds. The depository and the auditor are responsible for monitoring the transparency of investment investments. In addition, such funds are legally regulated in many countries, where the central bank is the one supervising different activities.

Both mutual funds and ETFs, which are chosen to invest in stocks and bonds, are very well diversified due to the fact that funds are invested in many different securities. In order to join investing in mutual funds or ETFs, you just need to purchase a share in them by purchasing a unit or share. All transactions with the purchase of shares or bonds do not depend on the investor and he cannot influence them.

The main differences between these instruments are in terms of their purchase and sale, as well as management.

4 Negatives To Know About ETFs

ETF stock meaningNothing is only sunshine and rainbows. Despite the obvious advantages, ETFs also have disadvantages. The weaknesses of ETFs lie primarily in the very essence of the instrument, as well as in the illiterate approach to investing in it. The risks of investing in ETFs are that losses are possible (if the fund is chosen incorrectly), as well as underestimated profits, compared to certain industries.


There Are Lots Of Fees

ETF shares allow a person with any investment experience to co-invest in dozens or even hundreds of companies, bond portfolios in different currencies and countries of the world, and so on for a relatively small fee.

The fund’s commission is more correctly called the Total Expense Ratio (TER). TER is the cost incurred by the provider in the course of its work. It consists of many expense items: listing and ensuring high liquidity, services of an administrator, depository, auditor, independent control, investment manager, and so on.

ETF costs cannot be limited by cost ratios. Since ETFs are traded on an exchange, they may be subject to commissions from online brokers. Many brokers have decided to reduce ETF fees to zero, but not all have done so. In general, when you are dealing with ETFs you need to know that there are fees that are connected with the asset.

Liquidity Issues

As with any value, when the time comes to sell, you will be affected by current market prices, but ETFs that are not traded as often will be more difficult to sell. ETF liquidity is a concept common to both buying and selling. Typically, if the market becomes volatile, many investors seek to lock in arrivals and the number of buy orders can drop sharply, stock spreads increase, and the ETF can lose liquidity. Therefore, the main rule of the investor is to invest only in the most liquid ETFs.

Using limit orders will help you control the execution price in case of large spreads or insufficient liquidity. If you decide to start trading foreign ETFs, then the best spreads and the greatest liquidity are observed during the business hours of the local market. It is for this reason that even the most liquid ETFs in the US market are best traded during the hours when US exchanges are open and traded. This will save you both on spreads and get the best ETF price.

Capital Gains Distribution

Mutual funds and ETFs usually issue capital gains distributions on an annual basis. These allocations represent the net trading profit earned during the year, divided into long-term and short-term profits. Distribution returns calculated using any of these payments may reflect imprecise annual returns. For example, calculating returns based on a distribution of long-term capital gains in excess of monthly interest payments results in a distribution of returns higher than the amount paid to investors in the previous year. On the other hand, a calculation using a capital gains distribution with fewer monthly interest payments results in a lower than actual distribution income.

No Room For Choice

By purchasing ETFs, an investor cannot individually select companies with higher growth prospects and better management, he must accept the “mass” nature of this instrument. When buying an ETF, an investor agrees to buy a basket of shares, which includes both the shares of the best companies in the given index and the outsiders. The investor should be aware that part of the capital allocated for the acquisition of ETFs will be written off as a result of the acquisition of shares of low-quality companies. Of course, this solution has the advantage of saving time and not worrying about who the Next Amazon will be. Having gained access to the entire market, the investor will invest some of the capital in another success in the stock market. However, the final rate of return on invested capital will be slightly below the benchmark.

What Did We Learn From This ETF Guide?

Within the ETF, the manager collects shares of various companies for some reason and based on them makes a fund.

Anyone can purchase shares of this fund, becoming in fact the owner of all the shares in which the fund has invested.

An Exchange Traded Investment Fund (ETF) is an index fund that allocates shares.

Management and control of the portfolio structure of the ETF fund investor is carried out online.

Common Questions On Exchange Traded Funds

Is ETF A Good Investment?

Despite the same principle of the device, not all exchange-traded funds bring profit to their shareholders. Even the same ETF in different reporting periods can show different levels of profitability. First of all, this factor depends on which index the fund follows. The most stable and highly profitable is the S&P 500 stock index and, accordingly, invest in those ETFs that reflect its dynamics. Shareholders of such funds can count on profits in excess of 100%, subject to long-term investments (5-7 years). An average return (about 40% over 5 years) is offered by funds investing in bonds.

What Is An ETF In Simple Terms?

ETF stands for Exchange Traded Fund. In practice, this definition means that an investor can freely buy and sell ETF shares on the exchange on the same principle as the assets of other companies. Investments in ETFs have several key differences: one share of a fund traded on an exchange contains several assets at once – securities, precious metals, currencies, and so on; ETF investors do not directly own shares of companies, that is, they do not have the right to participate in shareholders meetings;

How Is An ETF Different From Stock?

When buying an ETF, not one share is being purchased, but a whole package of compensated shares. Another advantage is that ETFs in the economy are specially selected securities that are very likely to generate fairly good interest rates.

For long-term investment, this method is not only profitable but also uncomplicated, even enjoyable. Indeed, instead of the usual complex analysis and a set of certain stocks, you choose the exchange-traded fund you need and get a pretty good profit without spending a lot of your time and energy on it.

There is also no need to pay management fees in ETFs. The ETF market structure is very convenient as it consists of the so-called two “layers”: the primary and the secondary market.

Some large ETFs have a mutual fund structure. ETFs are very profitable in building a reliable portfolio of stocks – they always have many opportunities for their representatives: lending, futures, and options to their investors.

What Is The Downside Of ETFs?

At the moment, there are about 10 thousand different ETFs, in which it is very easy for an untrained investor to get confused. In addition, there are organizations that are similar to ETFs but are not exchange-traded funds, which can also confuse the investor.

ETFs are complicated. It is associated with the emergence of ETFs, which are based not on classical indices, but on indices based on complex mathematical models, etc. In real market conditions, most of these indices turn out to be unviable over a long time interval.

Despite the growing popularity, the volume of investments in ETFs is quite low compared to the world ones. Therefore, if an investor plans to invest in a large fund from a well-known management company, it will have to provide access to foreign exchanges.