What Is An ETF?

what is an ETFIf you are asking the question What is an ETF? then read on. The term ETF stands for Exchange Traded Fund, which is a fund that is traded on a stock exchange like a stock. They come in a number of shapes and sizes, but the most common ones are designed to act as a proxy for an index, such as the S&P 500 or a commodity, like gold. By doing this they provide investors a way to trade a sector of the market without having to pick individual stocks. ETF’s combine the low expense ratio and tax advantages of index funds while granting the flexibility and liquidity of an ordinary stock.

Stocks of an ETF exist as baskets of securities which are purchased from the ETF in what are known as ‘creation units’ over a range of sizes. These are bought and redeemed, accumulated or sold, by institutional investors based on the supply and demand of the underlying index or commodity throughout the trading day, unlike a closed-end mutual fund which can only be settled at the end of each day.

This system grants the ETF the ability to minimize the arbitrage between the Net Asset Value (NAV) of the fund and the current value of that which it is designed to be a proxy for. Stocks of the ETF are purchased and redeemed at the current price. The price, however, does not rise with investor demand. Rather the holdings of the fund increase with investor demand. The share price rises and falls with the underlying issue.

In the case of a currency ETF share price represents a fixed amount of the currency, say $100, and the value of the fund, or number of shares outstanding rises and falls with investor demand. The fund is comprised of bonds of that country and the interest on the bonds is paid as a dividend. The share price changes with the exchange rate of the currency.

These investments vehicles, first introduced in 1989 have proven to be extremely popular with all kinds of market operators, from the long-term investor who wants to invest in a commodity without having to have a futures account to the day-trader who is looking for volatility.

There is also a type of fund known as the leveraged ETF where the fund architects attempt to multiply the volatility of an underlying asset. They come in 2x and 3x varieties, both long and short, through the use of derivatives, equity swaps and constant rebalancing to achieve the stated return.

Exchange traded Funds have lower expenses than traditional mutual funds as they have lower brokerage costs due to not having to invest contributions or fund redemptions. Their costs are generally less than 1%.

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Pete Southern

About Pete Southern

Pete is an active investor with knowledge of all sectors but his first love are IPO's. A failed day trader who now understands research. A love of economics and writing seen Pete begin to publish content for various finance blogs. Our main editor and collator of contributions, he is your point of contact via editorial at stockpricetoday.com

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