What is an exchange-traded fund (ETF) and how can they help investors?

ETFs or exchange-traded funds have become popular investment vehicles among beginning and experienced investors alike. As an ETF provides exposure to multiple assets, investors aren’t overexposed to the risk of a single asset falling in price. This makes them a popular choice as it allows people to diversify their investment in a wide range of securities with the purchase of a single ETF share. 

Understanding the basics of ETFs, along with the various types available, is crucial for investors to make informed decisions.

What is an ETF?

An ETF is a fund that trades on an exchange like an individual stock. Most of them aim to replicate the performance of a stock, bond or commodity index. The attraction for investors is it lets them put money in multiple assets without having to buy each one individually.

ETFs are traded on exchanges throughout the day, allowing investors to buy and sell shares at market prices. This means that the value of an ETF share fluctuates based on the performance of the assets that it holds.

What types of ETFs are there?

ETFs can be categorised by how they invest and what they invest in. 

Passive and active ETFs

Passive ETFs follow the market by tracking indices like the S&P 500. They follow a strict set of rules rather than having someone make the day-to-day investment decisions. Active ETFs involve portfolio managers who use their expertise to pick individual securities with the aim of either outperforming the market or delivering market-like returns but with less volatility. 

Broad market ETFs

A broad market ETF tries to match the performance of the S&P 500, NASDAQ-100, or another market index. These ETFs give investors access to many stocks at a low cost. These indices are constructed using a market-capitalisation-weighted approach, where the size of the company determines how much weight it has in the index.

Smart beta / factor ETFs

These ETFs track indices that use some other way to determine the composition or weight of each component. This could be to take an existing index such as the S&P 500 and simply weighting every security equally, instead of by size. Another example would be an index that selects stocks that have similar qualities, or “factors” (for example, those that have low volatility or pay higher dividends).

Sector ETFs

A sector ETF concentrates on the companies in a particular industry like technology, health care, or energy. It lets investors target growth opportunities or hedge against downturns in other sectors.

Thematic ETFs

These ETFs are really an evolution of sector ETFs. A thematic ETF selects stocks based on their involvement in some long-term trend, regardless of what sector classification the company happens to fall into.

Fixed income ETFs

A fixed income ETF invests in debt securities issued by companies or governments. Bonds have credit ratings assigned by independent rating agencies, which provide an indication of the riskiness of the bond. Higher risk bonds generally pay a higher income to compensate investors for the additional risk. Most fixed income ETFs aim to pay a steady income and are generally considered less risky than stocks. 

What other ETPs exist?

ETFs are a subcategory of exchange-traded products (ETPs). While ETFs tend to focus on diversified baskets of stocks, bonds or commodities, other types of ETPs can provide exposure to a single asset.

Digital asset ETPs

These ETPs give investors access to a variety of digital assets including cryptocurrencies like bitcoin, blockchains like Ethereum, and companies that benefit from decentralised finance. This type of ETP can be an easy way to include transformative technology in an investment portfolio. 

Exchange-traded commodities (ETCs)

An ETC follows the price of a physical commodity like gold and is backed by the underlying asset. It can offer investors a more efficient way to gain exposure to the commodity without the costs and administrative burden of personally buying, storing and insuring the commodity. An ETC is technically a debt instrument but is traded on an exchange just like an ETF.

What are some potential benefits of ETFs?

ETFs are flexible — just like stocks, you can trade them on a number of exchanges whenever markets are open.

You can see the prices of ETFs in real time and know exactly what securities they're holding on a daily basis, giving investors transparency. 

ETFs are also a cost-effective way of gaining exposure to a wide range of investments.

What are some potential risks of ETFs?

While ETFs are beneficial, they also come with market risks. This means that the value of ETFs can decrease based on market fluctuations. Also, some ETFs may have lower trading volumes, making them less liquid, and tracking errors can happen due to slight mismatches in ETF performance compared to the underlying index.

A world of choices

ETFs are powerful tools for building a diversified and cost-effective investment portfolio. Whether you're just starting or looking to expand your investments, they offer flexibility, transparency, and a world of investment choices for your portfolio.