An exchange-traded fund, typically known as an ETF, is a security that tracks a group of assets, a market index, currency, or commodity, but is traded like a stock. ETFs have grown to be a popular alternative to mutual funds within the last few years. ETFs can come in many different forms. Some ETFs track an index, such as the S&P 500, and their value depends on the value of the index. Other ETFS track commodities, and their prices fluctuate based on the commodity price. Most alike to the mutual fund are ETFs that track a group of assets. An ETF can be focused on any area, or diversified across many. An investor who thought that energy was going to be a growing market might not know what energy companies were good to invest in, and could invest in an energy-focused ETF. The ETF might hold a variety of stocks (selected based on their investment strategy), and ETF share price would fluctuate based on stock value and consumer demand. In the case of ETFs, market efficiency usually holds true—they typically trade at or near Net Asset Value (NAV), which is a stock/fund/index’s “true value”, not demand-driven price.
If you’re not quite following, let me paint a clearer picture. Imagine someone’s stock portfolio was focused on agricultural stocks. They have researched extensively, and bought 20 of the best agricultural stocks. This person is an expert on the field, and is certain that he picked companies to invest in that will increase in value. Now imagine that this person is an ETF manager, and he has amassed a multi-million dollar fund of agricultural stocks. His fund is legally arranged to have shares and trade on an exchange, like a single stock. So, when you buy a share of the ETF, you are buying a tiny position in a portfolio full of stocks! Imagine you only have $100 to invest, and want to get exposure to as many stocks as possible. You could buy 1 share of 5 or 10 different stocks, or you could invest in an ETF and gain exposure to a lot of stocks. The ETF’s stock price will be based on the value of these stocks – if they increase collectively, the price will as well. In the prospectus, the ETF will specify which stocks they hold, how much, and show balance sheet information.
ETFs are actually a security, as opposed to closed-end mutual funds, which trade on indexes but don’t have the characteristics of securities. Being a security means that investors get to have nifty things like options and limit orders, and they can short sell. Their security status also makes ETFs much more liquid than some other funds—it’s very easy to buy and sell quickly. ETFs are sold via authorized third parties (like a stock broker), rather than directly between fund manager and client (like a mutual fund).
Other advantages of ETFs include lower expense ratios (meaning greater returns for investors) and a more efficient tax structure than mutual funds. For individuals who want exposure to a wide variety of stocks with a small budget, an ETF can be a great option.