In the recent years, Exchange Traded Funds (ETFs) have become quite popular and many different products in this category have entered in the market.
An exchange-traded fund is an investment fund, similar to a mutual fund, which is pegged to a financial index. Unlike mutual funds, which are priced once in a day, an exchange traded fund trades on exchanges throughout the day, just like stocks. ETFs track indexes such as S&P500 in case of stocks. There are also Gold ETFs which track the Gold index such as London Gold.
There are many reasons why investors prefer ETFs.
1. The most important benefits is that they combine the features from both mutual funds and stocks.
2. The cost involved in buying and selling ETFS is low compared to index funds or mutual funds.
3. They are also tax efficient.
4. ETFs enable small investors to access the market of their choice. Most index funds have a minimum investment amount. However, with an ETF, an investor can even buy a single share. Similarly it is easier to buy Gold ETF, rather then physically storing gold.
Costs Associated with ETFs
ETFs have some costs associated to the. This fee, known as management fees, is deducted directly from the assets of the ETF. This fee is also referred to in the prospectus as “expense ratio”, “management fee”, or “investor fee”. This fee makes the returns from the ETFs lower than that of the underlying benchmarked index. It is expressed as an annualized percentage and currently ranges from less than 0.10% up to about 1.00%. The ETF’s management fee is included in the daily published NAV and thus is incorporated in the bid and asked prices in the secondary market.
Similar to stocks, you also need to pay commissions and/or transaction costs while buying and selling ETFs.
How are ETFs Valued?
An ETF’s NAV is generally determined at the close of each trading day. This value is then used to price creation and redemption units and is disseminated to the public before the market opens the next day. During the day, however, ETF shares are bought and sold at prices, which are determined by the market forces of supply and demand. An ETF’s market price is often closely related to its NAV, but it may differ. The following are some of the reasons why an ETF’s market price may differ from its NAV:
- Because ETFs are bought and sold in transactions between investors, at times there may be insufficient liquidity in the marketplace, which can result in an imbalance in buying and selling interest in an ETF. The creation/redemption process, however, is intended to mitigate pricing imbalances since professional traders may create new ETF shares and offer them for sale in the secondary market.
- The underlying components of the ETF (i.e., the basket of securities that comprise the ETF) may not be trading during the same hours as the ETF, or trading in a component security may be halted. In either event, the ETF may be priced to anticipate a future price in the underlying when it reopens for trading.
- The underlying components of the ETF may contain securities that trade infrequently or are based on relatively wide bid-ask spreads (e.g., corporate bonds or municipal securities) and are therefore difficult to price based on last sale data. This situation is not unusual for certain fixed income ETFs.
Risks Associated with ETFs
ETF shareholders are subject to risks similar to those of holders of other portfolios, such as mutual funds. In addition to these general risks, there are risks specific to each ETF, which are described in the relevant prospectus. Risks may include the following:
- The general value of securities held may decline, thus adversely affecting the value of an ETF that represents an interest in those securities. This could occur with equities, commodities, fixed income, futures, or other investments the fund may hold on behalf of the shareholders.
- For ETFs for which the stated investment objective is to track a particular industry or asset sector, the fund may be adversely affected by the performance of that specific industry or sector.
- Fund holdings of international investments may involve risk of capital loss from unfavorable fluctuations in currency exchange rates, differences in generally accepted accounting principles, or economic or political instability in other nations.
- Although ETFs are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate that performance because of trust expenses and other factors. This is sometimes referred to as “tracking error”.