What ETFs are

Exchange-traded funds (ETFs) are basically investment funds traded on stock exchanges, just like
common stocks. Investors must buy ETF shares through a brokerage and not directly from a fund company.
They bundle up investors’ money to purchase a diversified portfolio of stocks or bonds. Most ETFs are index
funds, which means that they passively imitate the performance of their corresponding index instead of
exceeding them. It also means that ETFs don’t need managers to choose which investments to hold or lose.

How ETFs work

Distributors can only buy or sell ETFs straight from or to authorized broker-dealers. ETFs are then
exchanged with bundles of the securities in creation units, which are large numbers of thousands to millions of
ETF shares. Approved participants can invest in ETF shares for the long term, but they mostly stand as market
markers on the open market. In other words, ETFs’ capability to exchange creation units to provide high
liquidity guarantee that their constantly changing market price come close to the net asset value (NAV) of the
underlying assets.

The valuation system for ETFs

ETFs are valued based on the values of a mutual fund or unit investment trust. They both can be
bought or sold at the end of trading day for its net asset value. They also have a feature called close-end fund,
which means the price of the shares can be higher or lower than its net asset value. It is easy to get close-end
funds and ETFs mixed up, since they are both funds traded on a stock exchange. They are still different though,
despite having the same valuation system.

The flexibility of ETFs

ETFs and mutual funds are very much alike. Thus, even new investors will have little to no difficulty in
understanding how they work. ETFs integrate the range of diversified portfolios with the ease of trading a
stock. Investors can buy ETF shares on margin, short sell the shares, or hold them for the long term. ETFs have
higher liquidity than mutual funds throughout the day. It means that they are not priced only after market
closings like mutual funds. ETFs constantly encounter price ups and downs as they are bought and sold.
Investors can invest as much or as little money as they want, since there is no minimum investment
requirement. Investors can also get into and out of their investment situation with minimum risk and payment.

The cost of ETFs

ETFs can be an attractive alternative for investors because they have lower fees than shares in mutual
funds. ETFs require fewer administrative expenses (less than 0,2% annually) than actively managed portfolios
(over 1% annually) in the same index. ETFs cost less because they imitate an index without trying to surpass it.
They usually don’t have high sales loads so there are fewer persisting costs to decrease investors’ returns. ETFs
are also less actively managed than mutual funds. Fewer trading activities mean fewer taxable distributions,
making it more tax-efficient.

Sources:

http://time.com/money/collection-post/2792014/what-are-exchange-traded-funds-etf/

http://www.nasdaq.com/etfs/what-are-ETFs.aspx

https://www.investopedia.com/terms/e/etf.asp

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