Exchange Traded Funds (ETF) is a type of investment fund, where the assets are traded on an exchange, in contrary to the more traditional investment funds. This type of investment fund is becoming increasingly popular due to the fact that it combines multiple aspects of the different types of traditional investment funds. ETF are the most traded product on exchanges and therefore an interesting aspect for investors.
Traditional Investment Funds
To understand ETF’s, an introduction to the more traditional investment funds can be useful. An investment fund is a company, which combines the investments of many small investors in order to buy stocks, bonds or other securities. Individual investor can buy shares of an investment fund, for which they will receive a dividend. A dividend is a portion of the profit made by investment funds and is based per share. A investment funds has several advantages over individual investments. Funds can implement large investments which will be impossible for single investors. Due to the large amount of funds available to the investment fund, a high level of diversification can be obtained, which can be used to minimize risks. Furthermore the trading is executed by experienced professionals. There is a fee required for investors to invest in an investment fund, which is usually a very small percentage of the total assets. These costs are usually settled with the net value of the investors investment. Depending on the type of investment funds, investors can either sell the share back to the company to make profit or minimize losses or sell them to other investors.
Net Asset Value
The Net Asset Value (NAV) is an important indicator for the value of a single share or the total amount of shares. The value is calculated through the total value of the assets of the fund minus the liabilities. The NAV can also be calculated per share, in which case the total value of all assets is divided by the number of outstanding shares. Depending on the type of investment funds, a share can be traded only on its NAV or can be traded on either a premium or a discount based on the NAV.
The shares of an ETF are not sold directly to individual investors but first to institutional investing companies, which are usually banks or other financial institutions. These companies buy the shares in so-called creation-units, which are collections of large number of shares. The shares are then sold via the institutional investors to the individual investors on an exchange, which basically makes the exchange the secondary market. Individual investors can buy and sell shares on the exchange, which has features similar to those on a futures exchange. Some of these features are options, the possibility to sell short or buy on margin. These investment funds can invest in a number of securities such as commodities, bonds and currencies. The underlying assets of these funds determines the net asset value (NAV). The moment the shares are made available on an exchange for public investors, the price will be determined by the balance between supply and demand. The spread between this market price and the NAV is usually close due to the adjustments made by the investing company. These companies usually adjust the number of shares to match the demand and thus keeps the market price close to the NAV. The NAV is calculated and announced very frequently and gives an indication whether the market price is in line with the value of the underlying asset. This gives investors an indication whether the share are trading at a premium or a discount and help them determine the best possible trading approach.
Advantages over traditional investment funds
The biggest advantage of ETFs is the possibility of trading on the exchange. In contrary to traditional investment funds where shares can only be traded to other investors or directly back to the issuer of the shares. With ETF shares, the investors have the ability to buy and sell their shares on an exchange, they have more options to trade their shares and there a lot more features for trading on the exchange. Some of these features are options, short selling and buying on margin.
Secondly the costs on a share for an ETF are lower than with traditional investment funds. First off all ETFs do not have front- or backloads. These loads are levied upon buying and selling shares with traditional investment funds. Furthermore the commissions on shares for an ETF are usually considerably lower than those for traditional investment funds. The possibility to buy only a few shares of an ETF gives small investors a chance to enter the market. Whereas the entry price for mutual funds can present an obstacle for small investors, who lack these funds. Thus an ETF is more accessible to all types of investors.
Diversity is an important advantage of ETFs. There are a number of ETFs, where many ETFs specialize in different industries or sectors. Therefore investors can choose which industry they want to invest in by choosing the right ETF for them.
An exchange provides a high level of liquidity. An exchange unites the numerous buyers and sellers of shares and gives them the possibility to trade the shares al during the trading day. This liquidity makes exchange traded funds more favorable than traditional investment funds. The liquidity also generates more market force on price envelopment for ETFs, whereas mutual funds are priced only once a day. The prices of ETFs are thus more volatile which creates more opportunities for investors to make profits or losses, depending on their actions based on the constant price movements.