Understanding ETFs (Exchange-Traded Funds)

An ETF (Exchange-Traded Fund) is a type of investment fund and marketable security that tracks an index, commodity, bonds or a basket of assets like an index fund. Unlike mutual funds, ETFs trade like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.

ETFs are important for providing investors with the flexibility of trading stocks alongside the diversification benefits of mutual funds. They are known for their cost-efficiency, lower expense ratios and tax advantages compared to traditional mutual funds.

• Liquidity: ETFs can be bought and sold at market prices at any time during the trading day.

• Transparency: Holdings are disclosed daily, allowing investors to see exactly what assets they own.

• Passive Management: Most ETFs are designed to passively track specific indices, reducing the costs and complexities of active management.

• Active ETFs: Some ETFs are actively managed by advisors who allocate assets, attempting to outperform the market index.

• Core-Satellite Investing: Using ETFs as the ‘core’ of your portfolio for stable returns and complementing them with ‘satellite’ investments for potential growth.

• Strategic Asset Allocation: Utilizing ETFs to represent different asset classes, maintaining balance through periodic rebalancing.

Imagine you’re interested in investing in the technology sector but don’t want to take the risk of investing in a single tech company. You decide to invest in a Technology Exchange-Traded Fund (ETF), such as the Invesco QQQ ETF, which tracks the performance of the Nasdaq-100 Index. Here’s how it works:

1. Your Investment: You purchase 10 shares of the ETF at $300 per share, investing a total of $3,000.

2. Diversification: By investing in the ETF, you now have exposure to 100 technology companies included in the Nasdaq-100 Index, such as Apple, Microsoft and Tesla. Instead of buying individual stocks of these companies, the ETF automatically diversifies your portfolio.

3. Management and Tracking: The ETF is managed by a fund manager who ensures the ETF tracks the performance of the Nasdaq-100 Index. If Apple’s stock weight in the index increases, the manager adjusts the ETF’s holdings accordingly.

4. Market-Like Trading: Just like individual stocks, ETFs trade on stock exchanges. If the ETF’s price rises to $320 per share, your investment value increases to $3,200. Similarly, if the price drops, your portfolio value decreases.

5. Dividends and Reinvestment: Some of the companies in the ETF pay dividends. These dividends are either passed on to you as payouts or reinvested in the ETF, depending on the fund’s structure.

6. Liquidity and Transparency: If you decide to sell your ETF shares, you can do so during market hours at the current market price. ETFs provide liquidity, allowing you to buy or sell shares anytime the market is open.

Let’s say the Nasdaq-100 Index grows by 10% in a year and your ETF mirrors that growth. Your initial $3,000 investment grows to $3,300. Meanwhile, you avoided the hassle of researching and managing individual stocks while benefiting from broad exposure to the technology sector.

ETFs offer a versatile investment option, suitable for both novice investors and experienced traders. They provide an efficient way to gain exposure to a wide array of assets, markets and investment strategies, making them a vital tool in modern investing.