Investment word of the day: ETFs — what are exchange-traded funds and how do they work?

Investment word of the day: An exchange-traded fund (ETF) is a combination of securities that provides diversification benefits of mutual funds with the ease of trading equities. It works similarly to an index mutual fund; the only key difference is it can be bought and sold on a stock exchange just like individual stocks.

Unlike mutual funds, which have a single closing price at the end of the trading day, the price of an ETF fluctuates throughout the day as it is actively traded on the market.

What is an ETF?

An exchange-traded fund (ETF) is a collection of different assets, such as equities, bonds, or other securities traded on stock exchanges. It enables investors to invest in many securities at once. When you buy an ETF, you’re investing in all the assets it holds, enabling portfolio diversification.

It is a popular instrument among investors as it is considered easy to trade, cost-effective, and allows investors to invest in a wide range of assets without buying each security individually.

These passive funds replicate the returns of a market index they track. Since these funds track an index, their returns fluctuate according to the specific index.

How does ETF work?

The assets constituting ETFs are owned by a fund provider, who tracks their performance and offers them to investors accordingly. The fund provider builds a basket of assets such as stocks, bonds, currencies and other securities. Similar to buying stocks in the market, investors can own a share from the basket of securities and can be traded throughout the day. The price of an ETF share fluctuates during the day on the basis of the value of the securities.

Types of ETFs

Here are some of the common types of ETFs.

1. Equity ETFs: These are invested primarily in a pool of company stocks and track the performance of a specific equity index. Equity ETFs trade similarly to individual stocks on exchanges.

2. Bond ETFs: These funds majorly deal with fixed-income instruments such as government bonds and debentures.

3. Commodity ETFs: These ETFs invest in a pool of commodities such as gold and silver. The price movement for this type of ETF is determined by the demand and supply of the commodity in the markets.

4. Sectoral ETF: These funds track the performance of a particular sector, such as banking, real estate, IT, energy and others.

5. Index ETFs: They try to replicate the performance of a market index such as Sensex or Nifty 50.

6. Style ETFs: These funds monitor a particular investment style or market size, such as large-cap value or small-cap growth, instead of market indices.

7. International ETFs: These funds track global markets such as the Nikkei Index of Japan or the Hang Seng Index of Hong Kong.

ETFs are not a one-size-fits-all investment, like any other option. It is necessary to evaluate them based on their characteristics and individual investment goals.