What Is ETF, How Does ETFs Work and How Many Types They Are?

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what is etf how does etfs work

ETF’s – Exchange Traded Funds fall under the category of Index Funds. They are not only listed but also traded on exchanges. You might have heard about stocks being traded in exchanges. ETFs follow the path of stocks in this way. Not only in India, globally, but also ETFs have opened a new panorama of investment chances. 

Particularly, they have opened new investment opportunities to institutional money managers. Even, they help retail businesses. They help investors gain broad exposure to stock markets. Particularly, they provide this exposure at a much lesser cost compared to other investment firms in real-time.

What are Exchange Traded Funds?

An ETF can be called a pool of stocks. They generally reveal the configuration of an index like BSE, Nifty and CNX Sensex. When they are like stocks, you might be wondering how the trading value of an Exchange Traded Funds is decided. Its trading value is decided based on the net asset value of the original stock that it denotes. 

In simple terms, you can think of Exchange Traded Funds as a mutual fund. But, you can sell and buy this mutual fund in real-time. Above all, its price changes all through the day, unlike mutual funds.

Again, ETFs are similar to mutual funds to a certain extent. This similarity lies with the management, regulation and structure of ETFs. Also, similar to mutual funds, ETFs are pooled investment vehicles. They provide different investment opportunities into a varied class of options, currencies, bonds, commodities, stocks or even a combination of these things. 

ETFs are similar to stocks because you can trade them in exchanges similar to stocks. Understanding the difference between open-end and close-end mutual funds will help you. The reason is that you can gain a better understanding of ETFs.

Difference between open-end and close-end mutual funds:

Traditionally, you can buy open-end mutual funds at any time straight from the fund company. Nevertheless, close-end mutual funds provide a set number of shares through Initial Public Offering or IPO. After an IPO, shares can only be purchased from or sold to other shareholders present in the open market.

One of the key differences between open-end and close-end mutual funds is that in the former your counterparty is always the fund company. But, in close-end funds and even in ETFs, your counterparty is not the fund company. But, your counterparty will be shareholders, who trade the entire day. They can either be trading over stock exchanges or directly. So, you can understand that you can trade ETFs at a price that suits you the most.

Are close-end mutual funds and Exchange Traded Funds are similar?

They are not the same. However, they are close cousins. The reason is that you can buy and sell both of them in stock exchanges. But, the difference between these two funds is that ETFs are not actively managed. Rather, the securities in an ETF just form a pool of investments. These pools intend to imitate an index as similar as possible. 

How To Choose Exchange Traded Funds and Index Funds?

When you intend to invest in ETFs, you will have to consider three main parameters. They are liquidity, tracking error and total expense ratio. Here are some details to know about these parameters:

Liquidity: 

As against mutual funds, ETFs are bought and sold in stock exchanges. So, liquidity is an essential factor to consider. When an ETF is not liquid, you might not be able to find buyers when you intend to sell the fund.

Tracking Error: 

The difference between the index and ETF return is referred to as tracking error. This is a crucial parameter considering the performance. The reason is that as an investor, you are actually going to invest in the index.

Total Expense Ratio: 

The total expense ratio should be of the low-risk category.

How Does Exchange Traded Funds Work’s?

As mentioned earlier, ETFs share the characteristics of both mutual funds and shares. They are bought and sold in the stock market as shares produced through creation blocks. You can buy or sell them from or to popular stock exchanges during the equity trading time. When you see changes in the prices of ETFs, it can happen due to changes in the cost of underlying assets. Let us consider that the price of one or more assets increases. When this happens, the price of ETF will also rise in the same proportion.

The shareholders in ETF will get dividends based on the asset management and asset performance of the particular ETF Company. As per the norms that the company follows, these assets can either be managed vigorously or inertly. A portfolio manager will take care of actively managed ETFs. He will do it after cautiously evaluating the conditions in the stock market. When assessing, he will undertake a calculated risk. He will do it by investing in companies with high potential. On the other hand, passively managed assets follow the trends of particular market indices. In this case, the investment is done only in the companies that are listed on the rising charts.

Types of Exchange Traded Funds:

Before you invest in ETFs, it is better to know their types. In fact, different types of ETFs exist. However, only four of them are popular. They are currency ETF, Debt ETF, Gold ETF and Equity ETF.

Conclusion:

Exchange-Traded Funds are profitable investment options for institutional money managers and retail business owners. So, you can choose this investment option and can reap the benefits thereof.

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