What is an ETF and How Does it Work?

What is an ETF and How Does it Work?

You may have heard about investing in ETFs but you do not understand what an ETF is all about. Or due to its similarity with index funds, and the larger term, Mutual Fund, you are confused about what exactly this ETF is.

Well, it is simpler to understand ETFs than you may have imagined. In this guide, I shall take you through every pillar of the concept, so that when you have read it properly, you will get to know all you need to know about ETF as a beginner.

What is an ETF?

ETF simply means Exchange-Traded Funds, and it is a fund or investment security that allows you to invest in a basket or an array of different assets (like bonds, stocks, money market instruments, and real estate) at the same time. This means that when you are investing in an EFT, you are investing in a wide range of industries and markets, with different market capitals.

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An ETF is closely related to a mutual fund and index fund. And to better understand the whole concept of an ETF, I believe understanding what a mutual fund is, will help.

So,

What is a Mutual Fund?

A Mutual Fund is an investment programme where a pool of money from different investors is used to invest in a large group of assets, (also called securities) like bonds, stocks, money market instruments, and other securities.

The different securities in a mutual fund are called its holdings, and these holdings are managed by professionals called Money Managers. The job of these professionals is to produce capital gains or income for the fund’s investors. Therefore, a mutual fund is said to be Actively Managed.

ETF and Index Funds also follow this same principle of mutual funding: Investing in a whole package containing different securities or assets, at a time.

But in EFTs and index funds, the investors manage their assets themselves, leaving out the services of the professionals as in mutual funds. Hence ETFs and Index Funds are said to be Passively Managed (there are cases where ETFs are actively managed though).

What Differentiates ETFs from Index Funds?

Exchange-Traded Funds and Index Funds share many similarities, that they sometimes confuse newbies. Nonetheless, there are striking differences between these terms you should know:

  1. ETFs track the stock market index, hence they are traded on stock exchanges like regular stocks. Index fund on the other hand tracks the performance of a benchmark index in the market.
  2. The pricing of ETFs happens throughout the trading hours, whereas index funds are priced only at the close of the day’s market.
  3. While index funds do not attract any commission or transaction fee, ETFs have a high expense ratio which ranges from 0.1 to 0.5%.
  4. The pricing of ETFs depends on the demand and supply in the market, but the index funds are priced based on the Net Asset Value (NAV) of the underlying securities.
  5. There is higher flexibility and liquidity attached to ETFs than Index funds since ETF investors can buy or sell during the entire trading hours.
  6. You will need a trading/brokerage account to buy and sell ETFs, unlike index funds where you do not need such.

Understanding ETFs

How Does ETFs Work?

I will believe that you have got a grip on what an ETF primarily is. So without fear, let us now explore how it works. We shall do this 3 steps:

Step 1:

ETFs are first created by the ETF Issuers also called the ETF Sponsor. To create this basket of assets, the ETF sponsor meets an Authorized Participant (AP). The AP is usually a large financial institution or Market Makers.

It is the AP that will then acquire the securities or assets that an ETF will contain before they will be handed over the ETF sponsor. In return, the AP will receive an equivalent value in ETF shares (called Creation Unit) from the ETF sponsor.

In step 1, an ETF is created by the ETF sponsor through and Authorized Participant.

Step 2:

In step 2 the ETF sponsor now begins to sell shares of the created ETFs to interested investors. And just like you are buying a share from a company, you buy a share of the ETF.

From here you should understand that the investor only owns shares in the ETF, and not in the underlying securities.

In step 2 investors buy ETF shares from ETF sponsors.

Step 3:

These investors will then trade (buying and selling) the ETF like stocks, throughout the trading hours on an exchange.

The price of an ETF depends on demand and supply so that when there is a higher demand than supply, the price will go up, and when there are more sellers than buyers, the price will fall.

In step 3 investors trade ETFs on an exchange depending on supply and demand to make a profit.


What is ETF?

Types of Exchange Traded Fund

ETFs can be classified based on their systems of management: Actively and Passively managed. But in terms of the types of ETFs considered here, we shall focus on the classification based on the type of securities held in EFTs.

Bond ETFs

Bonds are debt securities issued by a government or corporate bodies. They present good opportunities for investors as they offer relatively low investment risks. Unlike singular bonds, bond ETFs do not have a maturity date.

Currency ETFs

This type of ETF allows you to gain from the movement of different currencies in your ETF package. The liquidity of the foreign exchange market is very high, hence currency ETF is highly risky. Beginners are advised to be careful if they must invest in this type of ETF.

Sector/Industry ETFs

Let us assume you are predicting that a particular sector will boom, but you are not sure which company will be favoured most. Sector ETFs allow you to invest in a mix of different companies and allow you to maximise profit. It could be transport and logistics, power, oil, and gas, or banking.

Commodity ETFs

With a Commodity ETF, you will be able to bundle a group of commodities like crude oil, gold, silver, and agricultural products in one investment package. Some commodity ETFs focus on one commodity while others spread across different commodities.

International ETFs

International ETFs are ones that particularly invest in foreign securities/assets. They can provide you a good opportunity to diversify your investment holdings in different countries or regions.


Pros and Cons of ETF

Pros

  • It allows for vertical and horizontal investment diversification.
  • An ETF is transparent such that if you have access to the internet, you can search and see the price activity of a particular ETF.
  • ETFs do not attract a high expense ratio and you are taxed as an investor only when you sell-off the investment.
  • ETFs offer more trading convenience as investors can buy and sell around the trading hours.

Cons

  • There is a risk that an ETF can close unexpectedly, especially when the ETF in question has not Brough in enough to offset administrative costs.
  • Since the pricing of ETFs depends on supply and demand, some ETFs can be hardly traded. It becomes a problem when an ETF loses its liquidity.
  • Unlike an index fund where the funds are priced at the close of the market, ETFs allow investors to trade so long as the market is open. This can make you develop the habit of trading all the time; using this method will rather lead you to more loss than gains.

FAQs

What is Expense Ratio?

In ETF and stock, the Expense Ratio is the total percentage of funds charged by a broker to cover for management, advertisement, administration, and every other expense.

If an expense ratio of an ETF is 0.5% per annum, it means that 0.5% of the total funds will be deducted by your broker.

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Are ETFs a good investment?

In recent years, the popularity of ETFs has grown due to the advantages they offer to investors. However, it is a good investment option because they allow investors the opportunity to diversify their portfolio at a low cost; with ETFs, investors can invest in specific markets if they choose.

Are ETFs good for beginners?

Exchange-Traded Funds are a good investment decision for beginners. They offer a wide range of advantages that so many other investment alternatives do not offer.

They have a low expense ratio, they offer diversification and a wide range of investment options. But of course, you should be knowledgeable about it before you can make the move.

How can I get started with ETF investment?

The first step you should take if you want to invest in an ETF is to equip yourself with enough ETF investment education. Read books and take courses, if possible.

After that, you can open a brokerage account where you will have access to an ETF trading platform. Such brokerage platforms include

Now that you have gulped this information about ETFs, what is your next move? Invest?

Feel free to drop your views and suggestions in the comment box.

Dominicmario Ogodo

I am a freelance writer. With my years of writing and SEO experience, I will write you that superb blog copy that would have no other place on the internet than the first page of search results.

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