What is an ETF?

by Manshu on October 23, 2009

in ETF

Exchange Traded Funds (ETFs) are a relatively new phenomenon and are gaining popularity rapidly. This post outlines the key features of an ETF.

ETFs hold assets

ETFs are like mutual funds because they hold an underlying asset like stocks, debt, commodities future contracts etc. If you are new to the concept of an ETF, think of it as a mutual fund, and build your understanding from thereon. An example of an ETF is the SBI Gold ETF, which holds physical gold as its underlying asset.

ETFs charge you for their expenses

It takes money to run an exchange traded fund, and that money is recovered from investors. All ETFs charge you fee which is expressed as a percentage called: “Expense Ratio”. The lower the expense ratio, the cheaper the fund is. You should try to compare expense ratios between different ETFs, as that will tell you how much you have to pay in fees. All mutual funds do this too, so in this respect ETFs are like mutual funds.

ETFs do not need a minimum investment

Mutual funds have a minimum investment amount, and you need to at least invest that much in order to get in the fund. On the other hand, ETFs don’t have any such minimum investment requirement, and you can buy just one unit of an ETF, if that’s all you want.

ETFs trade all day long on a stock exchange

The above points discussed the similarities between a mutual fund and an ETF. This point discusses a key aspect in which ETFs are different from mutual funds.

ETFs trade on a stock exchange and can be bought and sold any time during a trading day. If you have a brokerage account and buy stocks through that – you can buy ETFs the same way. You can’t trade a mutual fund like this, but can buy or sell an ETF any time during the trading day. In this respect, an ETF is similar to a stock.

Brokerage on an ETF and stock is equal

Since you buy ETFs like you would buy stocks, the brokerage you pay on both are identical. The commission that your broker charges for stocks is the same that will be applicable for buying ETFs.

No loads are charged by an ETF

A lot of mutual funds charge front and end loads, which is nothing but fees that you pay when you buy or sell the fund. ETFs don’t charge any front or end loads to investors.

You can short an ETF

You can short an ETF if you wanted to. This can’t be done with mutual funds.

ETFs can be traded on a margin

Like stocks – ETFs can be traded on a margin.

Conclusion

ETFs are like mutual funds but offer a lot more flexibility than them. The downside is that they are easier to trade — and that tempts investors to get in and out quickly thereby incurring trading costs. All in all this is a useful innovation that opens up one more avenue for investors to gain exposure to the stock market.

If you want to read more, then here is another post about the differences between an ETF and in index fund that you may find useful.

{ 3 comments… read them below or add one }

manali October 25, 2009 at 11:07 pm

Very Well Written… I heard that in the US almost 80% of the volumes are ETFs….isnt that a shocker…compared to this, India is quite low..However with better ETFs like Gold BeES and Nifty BeES available, i think the Indian ETF market is coming of age

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Manshu October 26, 2009 at 5:07 pm

Thanks Manali. ETFs are easy to use and I think they are going to grow more because of their ease than anything else.

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Srividhya February 3, 2012 at 6:11 pm

Thanks for good information. I have heard that demat Account is needed for ETF invest . What is demat account? First! what is the difference between Gold ETF and Gold monthly saving scheme. I was totally getting confused for choosing the gold investment. Please suggest.

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