An exchange-traded fund (ETF) is a type of investment fund that trades on stock exchanges, combining features of mutual funds and individual stocks. ETFs hold financial assets such as stocks, bonds, commodities, or currencies and offer diversification benefits similar to traditional index funds.
Key Features of ETFs
Structure and Ownership
- ETFs divide ownership into shares held by shareholders, who indirectly own the underlying assets.
- Legal structures vary by country (e.g., corporations, trusts, or unit investment trusts).
- Shareholders are entitled to profits (e.g., dividends) and residual value upon liquidation.
Arbitrage Mechanism
- ETFs use an arbitrage mechanism to keep trading prices close to their net asset value (NAV).
- Authorized participants (APs) create or redeem large blocks of shares (creation units), ensuring liquidity and price stability.
Costs and Fees
- Expense ratios range from 0.03% for passive index ETFs to over 1% for specialty ETFs.
- Fees are deducted from dividends or asset sales.
ETFs vs. Mutual Funds
| Feature | ETFs | Mutual Funds |
|---|---|---|
| Trading | Traded intraday on exchanges | Bought/sold at end-of-day NAV |
| Transparency | Daily holdings published | Holdings disclosed quarterly |
| Tax Efficiency | Generally more tax-efficient | Capital gains distributions |
| Minimum Investment | No minimums | May require minimums |
Types of ETFs
Index ETFs
- Track market indices (e.g., S&P 500, NASDAQ-100).
- Examples: SPDR S&P 500 ETF (SPY), iShares Russell 2000 ETF (IWM).
Actively Managed ETFs
- Employ active strategies instead of passive indexing.
Bond ETFs
- Invest in fixed-income securities (e.g., corporate bonds, TIPS).
Commodity ETFs
- Hold physical commodities (e.g., gold, oil) or futures contracts.
Leveraged/Inverse ETFs
- Use derivatives to amplify returns or bet against indices.
Global ETF Market
- U.S.: Dominated by BlackRock iShares (34% share), Vanguard (29%), and State Street (14%).
- Regulation: Governed by bodies like the SEC and CFTC in the U.S.
FAQs
How do ETFs differ from mutual funds?
ETFs trade like stocks, offer greater tax efficiency, and have lower expense ratios compared to mutual funds.
What are the risks of leveraged ETFs?
Leveraged ETFs use derivatives, which can lead to amplified losses due to daily rebalancing and volatility decay.
Are ETFs transparent?
Yes, most ETFs publish holdings daily, though some active ETFs report quarterly.
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