According to Investopedia, an ETF, or exchange-traded fund, is a marketable security that tracks a stock index, a commodity, bonds, or a basket of assets. Although it is similar to mutual funds in many ways, its differentiating factor is that shares are traded like common stock on an exchange.
ETFs’ share prices will change throughout the day as they are bought and sold. The largest ETFs typically have higher average daily volume and lower fees than mutual fund shares which makes them an attractive alternative for individual investors.
While most ETFs track stock indexes, there are also some that invest in commodity markets, currencies, bonds, and other asset classes. Many ETFs also have options available for investors to use income, speculation, or hedging strategies.
In essence, ETF is a financial product that is easy to trade like a stock but also offers diversified exposure like a unit trust.
Simply put, it allows you to diversify your portfolio without having to buy individual stocks and/or bonds. As they are usually passively managed, the associated fees tend to be lower than those of unit trusts.
As you will have access to real-time information and prices on your portfolio, you will be able to know exactly what stocks or assets are included in the ETF that you have invested in. Moreover, you get access to established blue-chip investments such as those of STI and S&P 500.
What are the benefits to you
Like stocks, the return on an ETF depends on capital gain ie. when the price of the ETF units increase above the purchase price. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in case the fund is liquidated.
Do note that your ETF fund managers will determine if dividends are better re-invested or distributed as income to investors. Dividends are paid out in the same way as stocks. However, it is important to note that not all ETFs pay dividends.
What are the risks involved?
- Market risk
One of the risks involved in investing in ETFs would definitely be market risk as you are exposed to the volatility of the specific underlying assets or market(s) the ETF tracks. As this risk cannot be diversified, the ETF’s value will decline accordingly during adverse market conditions.
- Tracking error
Another risk would be tracking error, or the difference between the portfolio’s returns and the index it is meant to trace. This happens when the fund manager of the ETF is unable to perfectly replicate the performance of the index with the ETF tracks. The difference between the index and ETF returns are generally due to management fees, and timing differences.
- Foreign exchange
When an ETF is priced in a different currency from the local currency, you would also be exposed to foreign exchange risk. This can potentially increase or erode the ETF’s returns.
As with most investment products, it is possible in certain situations that you can lose, or gain, a substantial amount of money.