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What Is An ETF And How Do They Work

An Exchange Traded Fund is a special type of investment vehicle that owns assets such as stocks commodities or futures. Its shares are traded in the stock market like any other stock, leading to real-time share price fluctuation.

ETFs are designed to give investors exposure to diversified holdings in a particular field. Unlike stocks, ETFs hold multiple underlying assets as part of a diversification strategy. For instance, an ETF can own and track the performance of hundreds or even thousands of stocks across various fields.

How ETFs Work

An ETF structure is straightforward. A fund provider, in this case, selects underlying assets to own and track in the financial markets. The assets, in this case, could be stocks of companies, real estate, or even bonds. Once the fund is set up, the fund provider sells the shares of the company, which in this case is the ETF to shareholders.

Shareholders own a portion of the ETF but not the underlying assets. In addition to gaining from price appreciation of the ETF share prices, shareholder also get to earn dividends.

ETFs differ from mutual funds on the fact that they trade in the stock market. The lower fees also make them attractive compared to other investment products for diversification. While mutual funds charge, on average, 1.42% in administrative fees, ETFs charge an average of 0.53%.  ETFs also offer tax efficiency advantages, which ensure investors, get to earn optimum returns.

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Types of ETFs

ETFs are classified based on the assets they hold.

Bond ETFs: These type of exchange-traded fund own and track government as well as corporate and local bonds.

Industry ETFs: These types of ETFs track stocks in a particular industry. For instance, banking ETFs would track banking stocks while tech ETFs will track stocks of the biggest tech companies.

Commodity ETFs: Best known for investing in commodities ranging from Gold, Crude oil as well as Silver among others.

Currency ETFs: These types of ETFs provide investors an opportunity to gain exposure to a wide variety of currencies instead of investing in a single currency. The idea, in this case, is to insulate investors from the underperformance of one currency

ETFs Pros

  • ETFs stand out in part because they act as diversification vehicles as they allow investors to invest in diversified fields.
  • Tax benefits are also on offer with ETFs as investors are only charged upon selling their investments
  • ETFs provide a transparent and convenient way of wining different asset classes

ETFs Cons

  • ETFs are thinly traded leading to wide bid/ask spreads as well as low liquidity
  • ETFs come with additional costs in addition to expense ratio. Commission fees are common with some ETFs

Ruchi Gupta

Ruchi Gupta covers various beats from finance to technology and from lifestyle to hobbies. She has an MBA in Finance. Ruchi enjoys writing on celebrities and political news. She likes traveling and exploring places.

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