An ETF, or exchange traded fund is a very important and popular investment vehicle. An exchange traded fund is just what the name implies. It is a fund, or pool of assets and money sliced up among a larger number of investors. It is also traded on an exchange, so like stocks you can invest in them directly through markets.
If you’re looking for an etf definition, you could say that they are marketable securities (meaning they trade through financial markets) that are pegged to an index or a basket of assets, such as commodities. In other words, their value is derived from the underlying assets in the security itself.
Some common underlying assets include stock indices, such as the Dow Jones Industrial Average (DJIA), gold, oil, bonds, and foreign currencies. There are many other types of assets that etfs can be tied to. If there is a particular asset you want to invest in, you can probably find an etf for it.
ETFs make it easy to invest in these assets, and allow for easy trading through open financial markets. ETFs are a great choice for newer investors, or investors who don’t have a lot of time to provide direct oversight for their investment portfolio.
What’s essential to understand is that these etfs are not actively managed, but are instead tied to the underlying value of the assets themselves. No manager has to choose which assets will go into the fund. This helps keep management fees lower.
People who own etfs have an indirect ownership over the assets within the fund itself. They do not, however, have a direct claim to the assets. This is a small but important distinction.
ETF vs Mutual Fund
ETF’s and mutual funds are somewhat similar and also very different. Both are “funds”, which basically means that assets are pooled together, and then investors buy small slices of them. However, an etf is traded like a stock on common markets, while mutual funds are often purchased directly from the fund company.
This is a very important distinction. In practice, ETF’s are more liquid and easier to invest and trade than mutual funds. This doesn’t mean that mutual funds are bad investments, they can actually be great investments. However, mutual funds are not nearly as liquid as stocks, etfs, and some other types of investment. So keep that in mind if you’re trying to decide between an etf and mutual fund.
ETFs also involve much less hands on management as their price is basically pegged to the price of the underlying assets. As a result, there is less need to manage the fund directly. This keeps fees low and affordable in most cases.
With a mutual fund, on the other hand, somebody has to decide which stocks or other assets are going to go into the fund. This means the performance of the fund will come down to the fund managers and their choices. These fund managers, and especially top performing fund managers, will ask for hefty management fees for overseeing their funds. Often, these fees will have to be paid regardless of whether or not the fund itself is performing well.
Mutual funds can be a good investment, however they can be quite expensive. For this reason, many investors have been shifting to index funs and etf funds. Management costs are much lower, and often the returns are on par with managed fund.
EFT vs Index Fund
So how about etfs’ vs. index funds? These two funds are actually quite similar in that they are generally pegged to a stock index or underlying basket of assets. Index funds are more similar to mutual funds, however, in that they are not traded openly in markets.
Index funds often feature slightly lower management fees, and are generally a bit more stable. Often, investors will choose index funds over ETF’s if they are not as concerned with liquidity. If liquidity is a major concern, than an etf may be a better choice.
Index and mutual funds are often favored by passive investors, or investors who don’t make a high number of trades and who tend to hold onto assets for a long period of time. ETF’s, on the other hand, are favored by people and institutions who need to be able to exit positions quickly, and who need higher levels of liquidity.