Exchange-traded funds (ETFs) - Traders Terms

Exchange-traded funds (ETFs) are investment funds that track a basket of underlying assets, such as stocks, bonds, commodities, or currencies. They are traded on major stock exchanges, just like individual stocks, and can be bought and sold throughout the trading day.

ETFs offer investors a low-cost and convenient way to diversify their portfolios and gain exposure to a wide range of assets. They are similar to mutual funds in that they pool the money of multiple investors to buy a diversified portfolio of assets. However, unlike mutual funds, ETFs trade on stock exchanges like individual stocks, which means they can be bought and sold throughout the day at the prevailing market price.

ETFs can be passively or actively managed. Passive ETFs aim to track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average, by holding the same securities as the index in the same proportion. Active ETFs, on the other hand, are managed by investment professionals who aim to outperform the market by selecting securities that they believe will perform better than the market.

ETFs can be designed to track various investment strategies, such as growth, value, dividend, or sector-specific strategies. They can also be customized to meet specific investment objectives, such as socially responsible investing or low-volatility investing.

ETFs offer several benefits to investors, including low costs, diversification, liquidity, transparency, and flexibility. They have lower expense ratios than mutual funds, and their trading costs are typically lower due to their intraday trading ability. They provide investors with exposure to a broad range of assets and sectors, allowing them to diversify their portfolios and reduce risk. They also offer liquidity, which means that investors can easily buy and sell ETF shares at any time during market hours. Furthermore, ETFs provide transparency, as investors can easily see what securities are held in the fund. Finally, ETFs offer flexibility, as investors can trade them throughout the day at market prices, just like individual stocks.

One key benefit of ETFs is that they generally have lower expense ratios compared to actively managed mutual funds. The expense ratio is the annual fee that investors pay to cover the costs of managing and operating the fund. It includes costs such as management fees, administrative expenses, and other fees related to running the fund.

The expense ratio is expressed as a percentage of the fund's assets under management (AUM). For example, if a fund has an expense ratio of 0.50%, this means that investors pay $50 in fees for every $10,000 invested in the fund. Lower expense ratios mean that investors keep more of their investment returns, while higher expense ratios can significantly erode investment returns over time.

Since ETFs are typically passively managed, they have lower expense ratios compared to actively managed mutual funds, which require more resources and personnel to make investment decisions. In addition, ETFs have lower turnover rates, which means that they buy and sell securities less frequently, resulting in lower transaction costs.

Moreover, ETFs can offer investors even lower expense ratios through the use of index replication techniques, such as full replication or sampling. Full replication involves holding all the securities in an index, while sampling involves holding a representative sample of the securities in an index. These techniques can help reduce trading costs and lower the fund's expense ratio even further.

In summary, the lower expense ratios of ETFs compared to actively managed mutual funds can help investors save money over the long term and potentially earn higher investment returns. ETFs are a cost-effective investment option that can provide investors with low-cost exposure to a wide range of assets and sectors.