Exchange-Traded Fund (ETF) | Definition

/iksˈCHānj - trāded fənd/

a type of financial security bought and sold on the stock market; their purpose is to mimic indexes, sectors, or other assets.

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Sometimes, it is challenging to pick a good, passive stock that will provide a steady return for a long period of time. An investor’s main objective is to mitigate their risk and maximize their profits. However, at some point, all investors purchase a share of a corporation which ends with them losing a portion of their initial investment. Investors use one technique to lessen the risk taken on without negatively affecting their chances of profit by investing in exchange-traded funds (ETFs).


What are ETFs?


Exchange-traded funds or ETFs are a type of financial security bought and sold on the stock market. Their purpose is to mimic indexes, sectors, or other assets. Similar to index funds, these financial securities mimic the index’s performance but offer a share for a lower price.


As some corporations’ market share price is steep, it is difficult for some investors to invest in these large corporations, which might lead to them investing with fractional shares. However, ETFs offer investors the opportunity to purchase shares of a financial security that tracks the success of an abundance of high-worth companies.


Furthermore, they allow investors to buy shares of multiple assets at a lower price on the stock exchange. As not everyone has access to high levels of disposable income, ETFs are a good investment strategy for those with low capital, looking for long-term investments as they prepare for their retirement.


Difference Between Mutual Funds and ETFs?


The main difference between mutual funds and ETFs is that mutual funds are actively traded and managed while ETFs are not. Mutual funds are when a company pools the funds of many investors together and uses the pooled funds to purchase and hold shares of certain companies. 


The main objective of a mutual fund is to try and beat the market. The term ‘beating the market’ means a firm tries to exceed the average annual market return. As a result of these aggressive and ambitious procedures, mutual funds have a higher expense ratio to accommodate the more amount of research and manpower involved with their day-to-day transactions. 


On the other hand, ETFs are types of shares that are traded on the stock exchange. These types of shares follow and mimic the performance of certain industries. So, for example, if you wish to buy ETF shares that track the performance of the tech companies, you can purchase shares of NASDAQ: QQQ.


Different Types of ETFs


Now that you understand the main concept of exchange-traded funds, it is important to help you understand and differentiate between the different types.


Commodity ETFs

The commodity exchange-traded funds bundle the shares of the corporations that deal with physical commodities as a part of their daily operations. Some examples of physical commodities used by the companies traded on commodity ETFs are the following: gold, silver, agricultural, and natural resources; one of the main commodity ETFs is NYSEARCA: GLD. 


Bond ETFs

Moving on to bond ETFs, these financial commodities are traded with no maturity date. Although bonds themselves have a maturity date, where the bond's principal amount is repaid to the investor, the exchange-traded fund itself can be traded past the bond's maturity date. The bonds traded on the bond market range from those issued by governments, corporations, and states, which are called municipal bonds.


Actively Managed ETFs

Typically, exchange-traded funds are designed for investors who wish to not actively trade their portfolio and let their money accumulate wealth over time. However, these exchanges are ideal for those who wish to have their money actively traded. In addition, these exchanges actively try to beat the market, aiming to exceed the average market return. 


Inverse ETFs

Inverse ETFs work in the opposite way of regular ones. Whenever the market performs poorly, inverse exchange-traded funds perform better. This type of investment is suitable if you wish to mitigate the risk of your current holdings, also known as hedging. 


Industry ETFs

This type of ETF focuses on stocks in a specific industry, such as technology or healthcare. This type of financial security concentrates solely on one sector, so a higher risk is involved when investing due to lower diversification. 


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How to Purchase ETFs


Purchasing an ETF is quite simple. Similar to regular shares, you can buy and sell ETFs at any time on most trading platforms. Trading platforms such as Robinhood, TD Ameritrade, and Stash allow you to purchase various versions of this financial security at market price. 


Benefits of Using ETFs


Lower Risk

The main benefit of using ETFs, as mentioned above, is it diversifies your risk amongst many well-known, established corporations at a fraction of the price. In addition, by spending a lower percentage of your investment portfolio on exchange-traded funds, you can use the rest of your funds elsewhere to help expand your holds.


Creation of Passive Income

By increasing the number of positions you hold in different companies, you can increase your number of income streams by attaining dividends, allowing you to create passive income and generational wealth.   


Less Research Involved  

Another benefit is less research that needs to be done before investing. For example, when trying to pick out a specific stock to invest in, thorough research is required to make the best financial decision. As not everyone has the luxury of time to dive into a company’s financials, ETFs allow investors to purchase shares with less research as they track an abundance of stocks. 


Disadvantages of Investing in ETFs


Less Diversification

Although ETFs have many benefits, lower diversification is one main disadvantage that people need to become aware of. Although most ETFs cover many stocks to mitigate risks, some focus on stocks in the same industry. When the stocks are in the same industry, there is less diversification, which does not always mitigate the risk. 


Therefore, it is important to determine what type of ETF you are investing in to ensure that there is enough diversification to your liking that you believe your risk is being diversified. 


Despite all the benefits of ETFs listed above, it is essential to keep in mind that there will be risks involved when investing. Therefore, regardless of what you invest in, whether it be stocks, ETFs, cryptocurrency, etc., always do your research to make sure that you understand where your money is going and whether the investment will make you a profit. 


Disclaimer: The information contained in this article should not be considered financial advice. Always do your own research prior to investing. CapWay is not liable for any losses which may be incurred.


Main Image Credit: Maxx-Studio / Shutterstock.com

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