What is an Exchange Traded Fund and How Does it Compare to Indices and Shares?


An exchange traded fund (ETF) is a financial product that is managed as a trust by an investment company. The management is generally passive, meaning the investment advisor that manages the ETF buys and sells securities held by the ETF to make sure that the fund has the right balance of stocks within its portfolio. There are several benefits to trading ETFs. Here is how they stack up against indices and shares.

How is an ETF Constructed

An ETF is a group of stocks that are managed together to form a basket of stocks or assets. For example, there are ETFs on the S&P 500 index, as well as, an ETF that tracks the price of crude oil. While the ETF that tracks the S&P 500 index holds a basket of stocks, the ETF that tracks crude oil prices holds futures contracts. The goal of most ETFs is to track an underlying asset. There are passively managed ETFs as well as, actively managed ETFs.

A passively managed ETF follows another benchmark. The investment company that passively manages an ETF is constantly buying and selling securities to make sure the ETF tracks a benchmark. For example, the SPY ETF that tracks the S&P 500 index needs consistent adjusting as the price of the S&P 500 index rises and falls. An actively managed ETF is one where the managers are trying to outperform an underlying asset.

What are the Benefits of Trading ETFs

Exchange traded funds are traded like stocks and indices. They are generally considered the most liquid assets available. The average volume on the SPY ETF is more than 100-million shares. The SPY has more than 260-million in assets under management. If you are looking to trade an asset that has exceptional liquidity, ETFs fit that criterion. Additionally, not only to ETFs track baskets of stocks, bonds, currencies, and commodities, they also track groups of stocks called sectors. A stock sector is a group of companies that participate in the same industry.

For example, the stocks in the financial sector, which include banks, brokerage houses, and insurance companies have ETFs that track their price. There are ETFs on large-cap financial as well as smaller regional financials. Some of the most popular sector ETFs include energy, financials, utilities, discretionary, staples, and technology.

Why is ETFs Advantageous Relative to Indices and Shares?

ETFs are generally less volatile than shares but can provide some of the trading benefits experienced with shares. While you might not get the same returns if you trade ETFs like the XLK technology ETF compared to Microsoft, you will benefit if the entire technology group moves. ETFs that track an index should move in lockstep with that index. ETFs also provide you with an opportunity to pair trade. This is a strategy where you purchase one ETF and simultaneously sell another. If you believe the energy ETF will outperform the Utility ETF you can take that view. While you can do this with shares, your focus will be individualized as opposed to sector-wide. ETFs provide a broader view of the market and allow you to take a position in very liquid security.

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