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What is an Exchange Traded Fund?
Exchange Traded Funds or ETFs for short are an investment vehicle rapidly growing in popularity. While you may be familiar with mutual funds you may not be as familiar with ETFs. But you should be.
What is an ETF?
ETFs are a type of investment fund that trade like a stock on a stock exchange. Like mutual funds, ETFs are simply a vehicle by which an investment manager creates and manages a portfolio on behalf of a body of investors. Unlike a mutual fund which is typically designed as an open-ended trust or corporation, an ETF is typically designed as a somewhat closed fund that is traded on an exchange between buyers and sellers. The fact that ETFs trade on an exchange often leads to liquidity advantages over and above mutual funds.
For example, say you were invested in a typical mutual fund in Canada. If you wanted to redeem some or all of your units and cash out you would usually trigger a trade mid day which would be communicated to the mutual fund company who, in most cases, would redeem your units using the end of day Net Asset Value (NAV) of your fund. ETFs on the other hand require no such communication. In order to “cash-out” on an ETF you would initiate a sale on a stock exchange. Your sell request would be matched with a buy request by another party and the transaction would clear without ever triggering a redemption from the fund. Most ETF trades happen instantaneously without the need to wait for an end of day Net Asset Value calculation.
How do ETFs work and what do they invest in?
ETFs work by pooling together the capital of many investors into one investment vehicle. The ETF manager will then implement an investment strategy using the capital in the fund. By pooling large amounts of capital into one fund ETF managers can achieve economies of scale and implement strategies at lower cost and with superior diversification than individual investors would be able to achieve on their own. ETFs are used to access a broad array of markets and investment sectors such as domestic and international equities, debt securities, derivatives, and REITs.
What makes ETFs so unique?
One of the key features of many ETFs is the passive nature of their strategies. Although several actively managed ETFs do exist, the clear majority of ETFs currently on the market follow a passive investment strategy. For example, there are several Canadian ETFs that track a pool of stocks designed to replicate the overall performance of the S&P TSX. Such ETFs allow investors to create well diversified portfolios and access broad markets with very little capital invested. Prior to the advent of ETFs it was nearly impossible to allocate a small amount of funds to a large, well diversified portfolio without paying high levels of management fees.
ETFs are an investment vehicle growing in popularity with both institutional and retail investors. ETFs can be an excellent low-cost addition to help add broad market diversification to your portfolio.
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