The Secrets to Exchange Traded Funds

What is an Exchange Traded Fund?

An exchange traded fund is a security that tracks a major index, such as the S&P 500. Exchange traded funds is a security that bundles a commodity or a basket of assets similar to an investment fund, but is traded like a typical stock. Similar to stocks, all exchange traded funds will experience price fluctuations throughout a trading day as they are purchased and sold.

As a result of sharing trade characteristics with a stock, all exchange traded funds do not require their net asset value to be calculated daily, as is common with an investment fund or a mutual fund.

Advantages of an Exchange Traded Fund:

When an investor purchase an exchange traded fund, they will effectively diversify their investment, while possessing the ability to partake in short selling and purchasing on marching.

Exchange traded funds are viewed as attractive investment options due to their relatively low cost, their tax efficiency, and their ability to mimic stocks.

Another advantage of an exchange traded fund is that the investment possesses a lower expense ratio when compared to the average mutual fund. That being said, when investors buy or sell exchange traded funds they must satisfy the commission fees charged by the particular broker who executes the order.

Who Invests in an Exchange Traded Fund?

Exchange traded funds are typically purchased by authorized participants; typically large institutional investors such as hedge funds will purchase or sell shares of an exchange traded fund directly to or from the manager of the underlying fund. Typically these transactions are conducted in creation units (large blocks of tens of thousands of shares).

An authorized investor may invest in the exchange traded fund for a long-term benefit; however, the funds are typically purchased to act as a market maker on the open market; exchange traded funds possess the ability to exchange creation units with the underlying securities to offer liquidity and ensure that their intraday price is proportional or approximates to the net asset value of the fund’s underlying assets.

Individuals may also purchase shares of an exchange traded fund. Individual investors will typically use a retail broker on a secondary market to trade shares of exchange traded funds.

Features of an Exchange Traded Fund

Exchange traded funds combine the valuation features of a unit investment fund or a mutual fund; these funds can be sold or purchased at the end of each trading day for their net asset value. That being said, exchange traded funds also possesses the tradability feature of closed-end funds, which will trade at a price above or below the net asset value of the securities.

Exchange traded funds have been available since 1993 in the United States and since 1999 in Europe.

Exchange traded funds are similar to mutual funds in the sense that the investment offer investors exposure to a pool of securities; however, the shares of an exchange traded fund can be purchased and sold throughout the day similar to a stock on an exchange.

Unlike a traditional mutual fund, all exchange traded funds will not sell or redeem their shares at net asset value.

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