Exchange Traded Funds
An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are bought and sold from other owners throughout the day on stock exchanges.
An ETF holds assets such as stocks, bonds, currencies, futures contracts, and/or commodities such as gold bars, and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur. Most ETFs are index funds: that is, they hold the same securities in the same proportions as a certain stock market index or bond market index.
An ETF divides ownership of itself into shares that are held by shareholders. The details of the structure (such as a corporation or trust) will vary by country, and even within one country there may be multiple possible structures. The shareholders indirectly own the assets of the fund, and they will typically get annual reports. Shareholders are entitled to a share of the profits, such as interest or dividends, and they would be entitled to any residual value if the fund undergoes liquidation.
Investment uses and benefits
Costs: Since most ETFs are index funds, they incur low expense ratios because they are not actively managed. An index fund is much simpler to run, since it does not require security selection, and can be done largely by computer. Unlike mutual funds, ETFs do not have to buy and sell securities to accommodate shareholder purchases and redemptions. And thus, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses.
Taxation: ETFs are structured for tax efficiency and can be more attractive tax-wise than mutual funds. Unless the investment is sold, ETFs generally generate no capital gains taxes, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency compared to mutual funds is further enhanced because ETFs do not have to sell securities to meet investor redemptions.
Trading: ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day.
Since ETFs are publicly traded securities, investors can execute the same types of trades that they can with a stock, such as limit orders, which allow investors to specify the price points at which they are willing to trade, stop-loss orders, margin buying, hedging strategies, and there is no minimum investment requirement.
Market exposure and diversification: If they track a broad index, ETFs can provide some level of diversification. Like many mutual funds, ETFs provide an economical way to rebalance portfolio allocations and to invest cash quickly. An index ETF inherently provides diversification across an entire index, which can include broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.
Types
Index ETFs: Most ETFs are index funds that attempt to replicate the performance of a specific index. Indexes may be based on the values of stocks, bonds, commodities, or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.
Commodity ETFs: Commodity ETFs invest in commodities such as precious metals, agricultural products, or hydrocarbons such as petroleum. They are similar to ETFs that invest in securities, and trade just like shares; however, because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States. Commodity ETFs are generally structured as exchange-traded grantor trusts, which gives a direct interest in a fixed portfolio.
Currency ETFs: Currency ETFs enable investors to invest in or short any major currency or a basket of currencies. Investors can profit from the foreign exchange spot change, while receiving local institutional interest rates, and a collateral yield.
Actively managed ETFs: Actively managed ETFs are usually fully transparent, publishing their current securities portfolios on their websites daily. But some actively managed ETFs are not fully transparent. A transparent actively managed ETF is at risk from arbitrage activities by people who might engage in front running since the daily portfolio reports can reveal the manager's trading strategy. Some actively managed equity ETFs address this problem by trading only weekly or monthly. Actively managed debt ETFs, which are less susceptible to front-running, trade more frequently.
Inverse ETFs: Inverse ETFs are constructed by using various derivatives for the purpose of profiting from a decline in the value of the underlying benchmark or index. It is a similar type of investment to holding several short positions or using a combination of advanced investment strategies to profit from falling prices. Many inverse ETFs use daily futures as their underlying benchmark.