What is an ETF or Exchange Traded Fund

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 first came into operation in 1993 and, since then, have grown in popularity as an investment tool. They are passively managed, i.e., there is no fund manager.

ETFs are hybrid products that have the characteristics of a mutual fund as well as common stocks. An investor buys proportional shares to be part of the investment pool as in mutual funds. ETFs are managed by an investment advisor for a fee, similar to mutual funds. Like common stocks they can be traded in markets globally on a continuous basis. They have a continuous pricing and liquidity and can be bought and sold through brokerage accounts.

The main advantages of ETFs are access to all asset classes, hitherto available only to large institutional investors. This includes emerging market funds as well. Investors can include several investment strategies including different asset classes.

The transparency of ETFs is high and investors are clear about the elements in their ETF. The price and liquidity of ETFs is high and therefore investors value it over several other investment instruments.

ETFs also ensure tax fairness and tax efficiency. They have higher tax- efficiency because of lower portfolio turnover and in-kind redemptions. They offer securities in redemption, rather than cash. This helps avoid taxability.

Types of ETFs

There are several types of ETFs:

• Diversified passive ETFs: mirrors the performance of S&P 500, Dow Jones Industrial Average, and the MSCI exchanges.

• Fixed- income ETFs: these ETFs focus on bonds and have a stable portfolio.

• Niche passive equity ETFs: as the name suggests it is a basket of more closely chosen smaller companies in indexes.

• Active equity ETFs: these funds are chosen and managed by the fund advisor, rather than following any particular index. They have the probability of outdoing the market but there is also a risk of underperforming.

ETFs use a creation/ redemption mechanism that allows them to be more tax-efficient, transparent and less expensive than mutual funds. Let’s take a look at how this works.