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Exchange-Traded Fund (ETF) Definition and its Types

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ETFs

An ETF or exchange-traded fund is a combined collection of securities such as stocks, bonds, and commodities. ETFs are investment vehicles that are similar to mutual funds but are different based on their investment strategies. As the name suggests exchange-traded funds, they are traded on major stock exchanges such as NYSE and NASDAQ. In this article, we’ll talk about what an ETF is and what are the different types of ETFs that you should invest in.

Understanding ETFs

An exchange-traded fund allows you to buy a basket of stocks without having to own individual stocks. That means you can purchase ETF stocks from an ETF managing company that are being traded in stock exchanges. ETF company is a company that already has a huge number of shares from a variety of public companies and will be trading its shares as a unit on the stock exchange. Now the unit they are trading will be exactly like the stock they have purchased. That is if the price of the stock changes then the price of ETF units will also change. Unlike mutual funds whose price will be constant for a particular period of time. ETFs units are similar to any normal stocks in which you can also go for long positions and short positions. 

Generally, exchange-traded funds will purchase the stocks from multiple public companies, which creates diversification. Yes, there are ETFs that only focus on a particular stock industry, and the price per ETF unit will also be equivalent to the underlying asset. A wide variety of investment types are included in ETF units such as stocks, bonds, commodities, etc. Big ETF companies having a large market cap will have thousands or even millions of shares from a wide variety of industries from different sectors. 

ETFs vs Mutual Funds:

Mutual funds also have a pool of money like ETFs but they are not traded on stock exchange platforms. The mutual fund managing company will have a team of experts that will invest your money to get higher profits and will share their profits among their investors. While ETFs are just like any normal stocks. They also have a pool of money from investors who have invested in ETFs units. But there will be no expert team that will pick particular stocks for you to get high revenue. But they will have a mixed basket of securities that are already purchased for you. The ETFs unit is traded on the stock exchange. As a result, its price changes every moment during the trading hours. But mutual funds price is the same throughout the day. Let us understand other differences through a table:

Exchange-Traded FundsMutual Funds
ETFs are traded on stock exchanges.Mutual Funds are not traded on stock exchanges.
ETFs unit price changes during trading hours.Mutual funds will have fixed prices throughout the day
ETFs price will trade above or lower the Net Asset Value (NAV) of the company.Mutual funds price is equal to the NAV of that company.
As ETFs are traded on the stock exchange, they have to provide some tax to those platforms. Mutual funds do not trade on a stock exchange so no tax for those platforms.
ETFs units that investors purchase are not the actual securities of the public company. Mutual funds investment gives the investors the ownership of the securities they have purchased.
To invest in ETFs you do not require a minimum initial investment. The price per ETF unit is directly correlated to the stock prices owned by the managing company.To invest in mutual funds you will require a minimum initial investment set by the managing company.

Types of ETFs:

The most common types of exchange-traded funds that you should invest in are as follows:

  1. Equity ETFs

If you’re looking to invest in equities, exchange-traded funds offer a convenient way to do so. You can purchase ETFs that track indexes of large-, small-, or foreign-based companies, or those that focus on specific sectors like technology or banking. This flexibility makes equity ETFs a popular choice among investors.

  1. Fixed-Income ETFs

Financial professionals typically recommend allocating a portion of your portfolio to fixed-income securities like bond ETFs. Bonds are less volatile than normal stocks and help to maintain your investment portfolio.

  1. Commodity ETFs

Investing in commodities like gold, silver, or oil is very hard, especially for retail investors. But commodity ETFs help to achieve this. You can invest in the ETFs that keep track of those commodities. Watching the price increase of commodities ETFs, especially in the current crisis of gold and oil is always satisfying.

  1. Currency ETFs

These kinds of ETFs invest in a basket of currencies such as US dollars, pounds, Euros, etc. There are some ETFs that only invest in a single currency, but having diversity in choice makes them more secure.

  1. Specialty ETFs

Exchange-Traded Funds like leveraged funds and inverse funds have very high growth potential. But you need to do proper research on such ETFs as they are very risky too. Inverse funds are the funds that trade on the declination of the market. These funds do short selling to achieve their revenue, that is why they are also called Short Funds. 

Leveraged ETFs are the ones that borrow money or use financial derivatives to get a higher return on investment. If you see any ETFs saying 2X or 3X, then they are claiming to provide 2X or 3X in your profit. Seems attractive right? But not exactly. The amount of risk you will take is even higher than what you are getting.

For example, if the ETF provides 2X the profit you invested and suppose you invested $100. Now if the profit went by 10% you will gain 2X of it which will be $20 and your overall investment now will be $120. The next moment, the ETF fell by the same 10% then your loss will also increase by 2 times making it 20% of 120, which will be $24. i.e. you will lose more whenever the market falls. Also, leveraged ETFs are good for short-term investments as you can sell your position whenever you see profit, but investing in them for the long term is very risky.

  1. Actively Managed ETFs

As people see more benefits in mutual funds than in ETFs, actively managed ETFs are made to give advantages from both worlds. These ETFs have an active management team that makes investment decisions. The team analyzes the market and makes sector allocations and also changes their investment strategy based on market conditions. 

Final Words

Exchange-Traded Funds are one of the attractive ways to invest in the stock market. As ETFs have stocks from all kinds of industries, the price fall of one industry has very less effect on the ETF units due to diversification. As a result, they are safer alternatives than general stocks.

Also if you are searching for alternative companies to invest in then SPACs are also a good option. For SPAC investment, you can use a SPAC analytics tool such as SPACrun to get a good return on investment. Subscribe now to get your free trial.

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