An
Exchange Traded Fund is a type of investment fund that is traded on stock
exchanges. It makes investments in assets such as bonds, commodities, stocks
and trades on its net asset value on the trading day. Most of these funds
follow indexes such as stock exchange index and bond index. They provide
investors with combined benefits of a close-end mutual fund and an open-end
mutual fund. They are traded on a single stock at index linked prices. ETF
offers diversification of investment along with flexibility of holding a single
share at the same time. These funds are recently introduced in the management
but they are very popular abroad.
ETF's offer
the investor to choose from a pool of securities and assets in order to make
the investment. Therefore these funds are very much similar to mutual funds
except that these funds can be traded on a daily basis just like any other
stock on the stock exchange through a share broker. The asset value of the fund
is based on the performance of the index and the demand for that particular
share. The fund providing company invests the pooled out money from various
investors in the best performing stock on the stock exchange list. The
contribution of the investors is nothing but a 'share' of the fund. The initial
market price of the share is less however; it rises up as the performance of
the shares improves. Contrary, if the share fails to perform on the stock
market the market price of the share will fall.
Advantages of
Exchange Traded Funds
The following are some of the advantages of investing in ETF's.
Less Expensive: ETF's
are generally low cost funds because they are not traded and managed on a
regular basis. It is also free from secondary costs of marketing and
distribution.
Flexibility: ETF's
can be transacted at any part of the trading day. This flexibility is not
available in other types of mutual funds. Other types of mutual funds can be
traded only at the end of the trading day. This advantage enables the use of
hedging techniques and specifies the price at which the investors wish to sell
the shares.
Transparency: ETF's
have transparent portfolios which are priced at regular intervals throughout
the trading day.
Tax Efficiency: ETF's
comes with tax efficiency. These funds generate low capital gains because they
have a low turnover from their portfolio. The tax efficiency is even more
advantageous as securities need not be sold to meet the investor's obligations.
Diversification: ETF's
comes with an advantage of diverse investment. It provides investors with an
economical way of balancing their portfolios. It offers exposure to diverse
markets which includes country-specific markets, broad-based international
markets, industry-specific markets, commodity market, bond market and other
broad-based markets.
Risk
associated with Exchange Traded Funds
investing in any type of a mutual fund is not completely risk-free. There are some risks which can hamper the profit-making objective. An investor might encounter the following types of risks:
Economic
Fluctuations: Since ETF's are traded on various stock
exchanges, they are affected by the economical changes in the world. This is
because shares are directly affected by the ups and downs of the economy. It is
advisable to withdraw your investments from the market when you know that the
market is falling.
Sector-specific
Loss: The famous saying "Don't put all your eggs in a
single basket" is rightly applied here. ETF's whose portfolio consists of
investments in some specific sectors only face the risk of loss. Even if one
sector goes down, it would bring down the market value of your share of the
fund.
Low Returns: ETF's
can sometimes give you low return on investment. This is because the
performance of your fund fluctuates with the stock market. You cannot control
the stock market as it is not in your hands.
However, investment in Exchange Traded Funds
can bring you fruitful returns if the shares in this fund are regularly traded.
It is important to keep a watch on the stock market on a daily basis. You must
keep yourself updated with the price fluctuations. Use hedging strategies to
multiply your investment whenever possible.