Exchange-Traded Fund
An exchange-traded fund (ETF) is a fund that invests in assets and issues shares that trade on an exchange and represent ownership in the underlying portfolio.
An exchange-traded fund can track an index by investing in its underlying assets, such as stocks or bonds. The value of its shares depends on the index. According to the trading method, this fund is similar to stocks. An index is an indicator that allows you to track changes in the price of securities. To put it simply, it is a portfolio of securities diversified by certain criteria.
An exchange-traded fund is similar in many ways to a mutual fund, but there is one major difference between them.
Advantages and Disadvantages of an Exchange-Traded Fund
The advantages are:
- Convenient, often highly liquid exchange-traded instruments. The transaction can be carried out at any time of the trading day, if the trading turnover is large.
- An exchange-traded fund is a more diversified instrument. There are different securities here, one fund security may consist of hundreds of other securities, and financial risks are reduced. It is quite difficult to form such a portfolio on your own. Each ETF share represents a small diversified portfolio that an investor can purchase with one click for a moderate cost.
- The commission is lower than that of one of the traditional funds; basically, it is not paid separately, but is reflected in the ETF’s share price. The standard exchange commission is also charged additionally.
- Transparency — ETF holdings are regularly published, so investors are aware of all the changes that are taking place.
- A wide range of areas for investment.
- A variety of strategies. An emphasis may be placed on the broad market (diversification) or on narrow sectors. The management style can be either conservative or aggressive, and investments can be active or passive.
Active investments — transactions are made regularly, and assets are selected following an idea.
Passive ETFs replicate an index and are suitable for long-term conservative investments.
Gaining access to “privileged” assets. Unfortunately, many bonds can only be purchased in a large package, an exchange-traded fund allows for moderate investments available to a private investor. This further expands the possibilities of portfolio diversification.
Disadvantages of an Exchange-Traded Fund
With the increase in the number of such funds, ETFs may include less liquid or exotic securities, which can be difficult for investors to evaluate.
Not all ETFs can accurately reflect portfolio fluctuations. There is a risk of losses on country securities, since the index on which they are traded may be closed for some reason; for example, trading in the Market Vectors Egypt ETF was suspended during the Arab Spring.
Finally, ETFs can be liquidated. This has happened with niche securities in the commodity and Japanese sectors. Of course, in theory, the investor will receive a refund, but they may still incur transaction costs.
How to Choose an Exchange-Traded Investment Fund
- Determine the investment strategy: conservative or risky, active or passive. Adhere to the goals: diversification (distribute risks by the maximum number of securities), concentration (make a point bet on one idea), hedging (insurance of the main share of the portfolio from falling).
- You need an adequate amount of assets to manage the fund and a good turnover of securities trading to ensure their liquidity. Give preference to ETF securities with minimal deviation from the dynamics of the underlying portfolio.
- Prefer older ETFs, as they tend to hold more assets and have higher liquidity, with fewer deviations from their benchmarks, and lower risks of closure. Such securities have greater liquidity, they have fewer deviations from the base in the portfolio, and the risks of closing the fund are low.
