When you click through from our site to a retailer and buy a product, we may earn affiliate commissions. This helps support our work, but does not affect what we cover or how, and it does not affect the price you pay.
An ETF is a fund which is traded on exchanges and which tracks the trade assets. These assets can either be a stock index, bonds, a commodity or a general asset basket. There might be many similarities between ETFs and mutual funds but there are also some important differences. ETFs, for instance, are traded in stock exchange markets like ordinary shares.
ETFs are also traded severally and they tend to have higher average volumes even though the fees are lower. Investors have a myriad of investment options and opportunities to choose from when trading ETFs.
Understanding the basics of ETFs
Having given a brief introduction, it is now time to delve into the intricate details of ETFs. Most new investors often ask – what are ETFs? What are they all about? In basic terms, an ETF is a fund which has some underlying assets that are divided into shares. These assets can be anything from gold to oil futures and even bonds. Some ETFs come with a date when the fund will mature. This is not always what happens though as some can act as open-ended funds. The general rule is that ETF shareholders have a claim to the profits and they are paid in terms of dividends.
ETFs generally have better tax terms than mutual funds. The reason for this is that there are exchanges which are established for all trade activities. ETF sponsors, therefore, need not to alter their shares every time an investor expresses interest. Instead, the shares can remain listed on the exchange and thus attract lower tax rates. Redeeming shares means that a tax is applied and ETF sponsors need to do everything possible to keep the taxes down. The ETF market has affected the mutual fund market to an extent where the expenses incurred in the mutual fund market have been falling. The ETFs nevertheless remain lower cost investment options and they are very popular with investors.
Important facts of the ETF market
When trading on the ETF market, it is important to take note of some of the most important characteristics of the market. One of the key issues to consider is the creation and redemption mechanism. ETF creation is the process where a participant in the market can buy shares of the ETF in the market and sell them to the fund. By doing this, the participant will end up increasing the number of ETF shares in the market. If other factors in the market do not change, the price of the ETF will ultimately come down to equal the net asset value of the funds.
As for ETF redemption, it is a process where a market participant aims at reducing the supply of the ETF shares in the market by buying its shares from the open market and selling them back to the fund. In order to get down the number of ETF shares in the market though, other factors must remain constant. This does not always happen in the market as there are many factors influencing. In most instances though, it is possible to bring the market to a near equilibrium where the prices of an ETF share are almost equal to the net asset value.
Merits and demerits of trading ETFs
Like any other investment option, there are a number of advantages and disadvantages associated with trading ETFs. Some of the main advantages of trading ETFs include:
- Lower average costs and tax efficiency
- Access to a diverse market of index funds
- Availability of a wide range of trading options
There are also a number of disadvantages associated with trading ETFs. Some of the most common ones are:
- Some ETFs are not diversified at all
- The market of ETFs can be unstable
- It is not always possible to get sufficient information on certain ETFs
There are indeed many ways to gain profit with investments in the ETF market. This market offers investors a chance to access low-cost investment options in a market that is otherwise quite expensive. ETFs have many similarities with stocks and for this reason, many investors will be familiar with the process of trade. There are nevertheless a number of disadvantages and risks associated with ETFs. Every budding trader needs to analyze the market independently and go for investment options that are familiar.