Exchange Traded Funds (ETFs) Explained

What are Exchange Traded Funds?

Exchange Traded Funds (ETFs) are, as the name suggests, investment structures, or investment plans, that are traded, as shares, on the various stock exchanges around the world.

They typically involve a portfolio of stocks, bonds, indices (such as the FTSE 100 index, for example), commodities etc., and trade on the stock market is much the same way as conventional shares; they can, for example, be bought on margin, or bought short.

ETFs can be bought in small denominations, allowing investors to spread, or diversify, their assets over a variety of shares, even where the total amount invested is small. ETFs require no minimum investment – other than, of course, the market price of one so-called "creation unit" – and are therefore useful for diversifying investment, in a single transaction, without creating funding issues.

ETFs are eligible for inclusion in ISAs ("Individual Savings Accounts"), but attract no stamp duty, and annual costs – which may be as low as 0.1%, plus, of course, stockbroker costs – compare very favourably with other investment schemes, such as OEICs ("Open Ended Investment Companies") and unit trusts.

Exchange Traded Funds Features, Benefits & Considerations

In common with other collective, or mutual, funds an ETF is an investment scheme that allows the assets of multiple investors to be pooled, and invested in such a way as to generate regular income, capital appreciation, etc., based on the requirements of individual investors. ETFs are, however, what are known as "passive" investments; they are not actively managed, by a fund manager, on a day-to-day basis, and shares are bought, and sold, only to reflect movements in the market. This can be an advantage, in terms of taxation, when compared to actively managed funds; the low turnover of securities means that capital gains liabilities are not accumulated as the value of the portfolio increases, as is the case with traditional mutual funds.

In addition, ETFs are priced continuously throughout the trading day – unlike traditional funds, which are priced just once – so investors know the price immediately prior to buying or selling. Liquidity is typically high, although this does depend on the liquidity of the underlying assets themselves; the higher the liquidity of the underlying assets, the more quickly the "creation units" – sets of shares, etc., that constitute the units of a fund – can be assembled, and traded.

Another characteristic of an ETF is the opportunity for buying, or selling, shares based on the difference between the value of the ETF, itself, and the underlying NAV, or "Net Asset Value"; if deviation between the two values occurs, and ETF shares are trading at a price higher than the NAV, for example, an investor may buy the underlying assets directly, redeem them for a certain number of ETF shares, and sell those shares at a profit. If, on the other hand, the reverse is true, an investor may buy ETF shares and redeem them for the underlying assets, which, again, may be sold for a profit.

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