What is an exchange-traded fund (ETF)? How do ETFs work?

What is an exchange-traded fund (ETF)?

How do ETFs work?

Exchange traded funds are investment instruments having the most soughtafter attributes of both stocks and mutual funds. While mutual funds are famous for the diversification benefit they provide, shares remain a hot property because they are highly liquid and can be freely traded.

Exchange-traded funds get you the best of both these worlds, i.e., they can be traded on an exchange like stocks and provide the benefit of diversification like mutual funds.

Let us understand how this instrument works.

Understanding Exchange Traded Funds ETFs are a collection of securities that can be traded on stock exchanges like normal stocks. They can also be a combination of similar securities as well as heterogeneous securities. Usually, ETFs are created to track popular indices or sectors, but it is possible to find stocks, bonds, real estate, commodities, currencies and debentures etc., in the form of exchange-traded funds as well.

Basically, any asset class that has an established index can be crafted into an ETF.

To learn more about different asset classes and how you can expand your portfolio, read our Beginners Guide On Asset Allocation in the Teji Mandi blogs.

Like share prices, the trading price for exchange-traded funds is determined by market buying and selling forces.

When you buy an ETF, you invest in the securities that the ETF has invested in, much like with mutual funds. The fluctuations in the prices of ETFs can be attributed to the changes in the price of the underlying securities the fund has invested in. If the majority of the invested securities are trading with a positive bias (seen in the upward movement of the index the ETF tracks), the ETF’s price will go up in line, and the converse is also true.

ETFs too can be actively or passively managed. In actively managed funds, portfolio managers are designated with duties of accessing the fund’s performance at all times and making calculated adjustments to drive in more returns. While in the case of passively managed funds, there is not much rebalancing happening. The strategy is pre-decided and choice securities are chosen for investment based on which index they want the ETF based off.

How are ETFs different from mutual funds?

Though ETFs mimic mutual funds on several fronts, like allowing investors to buy multiple securities with a single investment and getting the diversification benefits, ETFs still have some key differences.

Exchange traded funds are highly liquid instruments like stocks, and can be freely traded during the market hours. The unit price, called the NAV, as is with mutual funds, changes by the minute like it does with stocks as forces of demand and supply act out during the trading session. On the other hand, the NAV of a mutual fund is decided at the end of the day based on the closing price of the underlying securities that comprise the mutual fund.

Buyers of ETFs can exercise features like placing limit orders, stopping losses, target prices, etc., that you get with shares; however, only plain vanilla buying and selling is possible in the case of mutual funds.

Moreover, ETFs don’t have minimum investment criteria like mutual funds, and you can buy as low as one share of an ETF. Know more about exchangetraded fund