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Exchange-Traded Funds (ETF): Definition, History, How it Works          

Exchange-Traded Funds (ETF): Definition, History, How it Works, and Types

Exchange-Traded Funds (ETF): Definition, History, How it Works, and Types

Exchange-Traded Funds (ETFs) are a type of investment fund that comprises a collection of underlying securities. EFTs include all types of financial securities, such as commodities, debts and equities. Like Mutual Funds, EFTs allow investors to pool money and invest in a bundle of assets. However, unlike mutual funds, ETFs can be traded through exchanges. 

ETFs in the stock market lower the risk involved in investing in a single stock by reducing the exposure through a bundle of stocks. 

ETFs trace their origins to the 1900s when it was first created to allow investors access to indexed funds. The idea originated from index mutual funds, and there was an urge to make an investment fund that included all the benefits of mutual funds but was at the same time more accessible, less expensive and less complicated. ETFs were first launched in 1900 by the Toronto Stock Exchange. 

ETFs function through the underlying assets of the fund. The underlying ETF assets can include stocks, bonds, commodities or any type of financial security. The underlying assets of the ETF are owned by the ETF provider, who creates a fund based on the underlying assets. Shares of the fund are then offered to interested investors, who can trade the shares like stocks on the exchange. 

There are ten types of Exchange Traded Funds (ETFs), including commodity ETFs, leveraged ETFs, inverse ETFs, sustainable ETFs, currency ETFs, equity ETFs, factor ETFs, stock ETFs, specialty ETFs and actively managed ETFs. In order to purchase and trade any type of ETF, investors must have an ETF account with a brokerage of their choice. An ETF account is a trading account that allows investors to buy and sell ETF shares. To buy ETFs, investors only need to login into their trading accounts. Investors can choose from the different ETFs available based on their investment goals. Examples of ETF markets include Index ETFs, Gold ETFs, Currency ETFs, Sector ETFs, Bond ETFs and Global Index ETFs. 

What does an Exchange-Traded Fund (ETF) mean in the Stock Market?

Exchange-Traded Funds (ETFs) are a type of investment security that holds other underlying assets, including stocks, bonds, commodities, currencies etc. In the stock market, ETFs are generally designed to track a particular stock index. A stock index collects the top stocks for a specific sector. For instance, a NIFTY 500 ETF includes stocks of all 500 companies that are listed in that specific index. 

ETFs can be purchased through stock exchanges worldwide, including the National Stock Exchange of India, the Bombay Stock Exchange, the London Stock Exchange, the New York Stock Exchange etc. ETFs are a key part of investment strategies as they reduce the risk of exposure by investing in a diverse portfolio of assets. ETFs, like mutual funds, allow investors to pool money and invest it in a diversified portfolio consisting of any number of securities. However, unlike mutual funds, ETFs are more accessible to investors as they can be traded easily through exchanges and involve a much smaller expense ratio. The expense ratio refers to the charges levied on the investors by the providers of the investment funds as part of their operation and management fees. 

ETFs differ from stock in being investment fund that includes different underlying securities. Buying shares of an ETF allows investors to make returns from all the underlying assets of that fund, which includes a bundle of stocks from different companies, bonds and other securities. The ownership of the assets of an ETF, however, remains with the ETF provider. On the other hand, stocks are portions of ownership offered by individual companies in the stock market

How did Exchange-Traded Funds (ETFs) start?

Exchange-Traded Funds (ETFs) were started in the early 1900s through attempts to create investment securities that included the diversity of mutual funds but were, at the same time, more accessible and cost-effective. The first attempt at investment security that resembles today’s ETFs was made in 1989 by the S&P 500 index in the United States. The security was called an Index Participation Share. However, the US federal court declared they had to be traded through the futures exchange as they functioned like futures contracts. The first successful attempt at creating a modern ETF took place in 1900 by the Toronto Stock Exchange. The ETF was based on the Toronto 35 Index. In America, the first ETF was launched by the S&P 500 on January 22, 1993.  In India, the first ETF was established in 2002 based on the Nifty 50 Index by the National Stock Exchange (NSE). 

How do Exchange-Traded Funds (ETFs) function?

Exchange-traded funds work in a manner that is similar to the functioning of a mutual fund. In an ETF, the provider first plans and purchases a bundle of securities comprising assets from different asset classes. Each type of asset is based on a respective index. The Exchange-Traded Fund provider owns the ETF’s underlying assets, which usually include bonds, commodities or any financial instrument. Secondly, interested investors of ETF are offered shares of the ETF. The ETF provider retains the ownership of the underlying assets. The shares of the ETF can be purchased through a stock exchange, just like buying any stock. Thirdly, the ETF can be traded through stock exchanges. ETF share prices are susceptible to daily fluctuations and can be traded through exchanges throughout the day. 

What are the Types of Exchange-Traded Funds (ETFs)?

There are primarily nine types of Exchange-Traded Funds, which are listed below. 

1. Commodity ETFs

Commodity ETFs are ETFs in which the underlying assets comprise physical commodities such as gold, crude oil, agricultural goods, energy products, metal products etc. Commodity ETFs either focus on a specific commodity in storage or track the index of a particular commodity. Commodity ETFs can also be based on futures contracts related to a commodity. Commodity ETFs are useful for investors who wish to diversify their investment portfolios. Investors use commodity ETFs to provide a safety net for investors when the stock market is down. Commodity ETFs also help investors to hedge against inflation. 

The main pro of investing in commodity ETF is that it allows investors to expand their investment portfolio into commodities without managing and storing the physical commodity. Commodity ETFs also decrease risk exposure by spreading out the investment portfolio. The main disadvantage of commodity ETFs is that the trading volume is low compared to other securities, such as stocks. Low trading volume creates a huge gap between the bid price and the asking price, and investors often do not get the prices they ask for. 

2. Leveraged ETFs

A leveraged ETF is an exchange-traded fund that uses financial derivatives and debts as its underlying asset. Leveraged ETFs use borrowed funds to magnify any gains in the specific index it tracks. Leveraged ETFs are built on the investment strategy of leveraging, wherein borrowed funds are utilized to enhance the effect of price movements. Investors commonly use leveraged ETFs to maximize their returns and make gains that exceed the underlying indices. Leveraged ETFs are used mainly by investors for short-term gains based on speculations on an index. The main advantage of investing in leveraged ETFs is that it gives investors access to various securities to trade from. However, the expense ratio of leveraged ETFs is higher than that of other ETFs. Leveraged ETFs are also riskier than other ETFs and can potentially result in huge losses. Leveraged ETFs are also unsuitable for long-term investments as the underlying assets, derivatives such as options and futures contracts, are short-term investment assets with expiry dates. 

3. Inverse ETFs

Inverse ETFs are a type of ETF that are designed to make profits from declines in the underlying index. Inverse ETFs, as the name suggests, function inversely with the benchmark index’s price movements. Inverse ETFs are called ‘short ETFs’ or ‘bear ETFs’ since their underlying principle is similar to short selling in a bear market. Inverse ETFs typically invest in derivatives like futures contracts which are agreements to buy or sell securities at a certain price on a specified date in the future. Investors of inverse ETFs place bets on the likelihood of the market declining. The inverse ETF rises if the market declines, which is how returns are made. The biggest advantage of inverse ETF is that it allows investors to make money when the market is on a decline, so investors include it in their investment strategies. Inverse ETFs are, however, more expensive than normal ETFs. 

4. Sustainable ETFs

Sustainable ETFs are a type of ETF that invests only in stocks of companies that adopt a sustainable approach to environmental and social concerns. Sustainable ETFs are suitable for investors who seek to avoid companies involved in environmental pollution and exploitation. Sustainable ETFs track social indices that list companies with a high Environmental Social, Governance (ESG) rating. The ESG rating is given to companies based on their adherence to environmental and social governance standards. Social indices avoid stocks of companies whose products negatively impact the environment or society. Examples of companies that offer sustainable ETFs include companies producing arms, nuclear power, tobacco and alcohol products. Sustainable ETFs form a crucial part of the investment strategies of traders seeking to practice ethical trading. The main advantage of sustainable ETFs is that they are a convenient option for those who want to invest in socially and environmentally responsible companies. However, limiting oneself to sustainable ETF restricts investors to a few companies and unethical companies very often perform better than the ethical ones financially. 

5. Currency ETFs

A currency ETF is a type of ETF that invests predominantly in foreign exchange. Currency ETFs allow investors to get exposure to the currency’s market and gain from changes in exchange rates. Investors use Currency ETFs to diversify their investment portfolios and hedge against risks. The primary advantage of using currency ETF is the exposure to the forex market through a fund that it gives without the hassle of taking on the trades individually. However, the forex market is susceptible to fluctuations based on geopolitical relationships between countries, which can also affect the ETFs. The impact on the forex markets also tends to be massive, and currency ETFs can lead to losses. 

6. Equity ETFs

Equity ETFs are those that invest in company stocks. Equity ETFs comprise a basket of equities from all the companies on the stock index it is tracking. Equity ETFs are the most common type of exchange-traded funds. Equity ETFs expose investors to equities from hundreds of companies through a single trade. Within Equity ETFs, there are sub-categories such as small-cap ETFs, healthcare ETFs, Emerging Market ETFs etc. The main advantage of equity ETFs is that they offer the diversity of mutual funds without expense ratios that are as high as mutual funds. Equity ETFs also tend to be very transparent as they are designed to replicate the benchmark index as closely as possible. The main disadvantages of equity ETF are the lack of liquidity and the low trading volumes. 

7. Factor ETFs

Factor ETFs are a type of ETF that tracks a specific market index that has recently gained popularity. Factor ETFs are more tailored than normal ETFs and are designed to deviate from the index it tracks. The principle behind factor ETF is that in place of blindly tracking the index, the returns can be maximized if the fund deviates to a certain degree from the index. The amount of deviation of the factor ETF from its tracking index is called a bias. Investors opt for factor ETFs to minimize risk exposure and maximize returns. Factor ETFs are designed to increase the portfolio’s efficiency and performance. However, as they are a relatively new concept, investors are unsure about their effectiveness and are unwilling to invest in them.  

8. Stock ETFs

Stock ETFs are similar to mutual funds in that they hold a diversified portfolio of stocks, but they differ in that they trade like a stock on an exchange, with prices that fluctuate throughout the day.

Stock ETFs can provide investors with exposure to a particular market sector or industry, such as technology or healthcare, or they can track a broader market index, such as the S&P 500. ETFs offer several benefits to investors, including diversification, lower costs, and greater flexibility.

Investors can buy and sell them throughout the day at market prices. This makes them an attractive option for investors who want to trade frequently or who want to invest in a particular sector or index but don’t have the time or expertise to invest in individual stocks.

9. Speciality ETFs

Speciality ETFs are ETFs focused on stocks and securities of a specific sector or industry. Speciality ETFs are also known as sector ETFs. Examples of sector ETFs include those that track the energy, technology, healthcare, arms sector etc. The main difference between a speciality ETF and other ETFs is that speciality ETFs focus on a particular sector, whereas others tend to focus on the broad market. The main advantage of speciality ETFs is that it allows investors to invest in an entire sector and track all the major indices within that sector. Using speciality ETFs, investors can avoid the hassle of picking and choosing individual securities from their chosen sector. Sector ETFs have three main advantages, including less risk, ease of research and good diversification options, particularly when spread across different industries. However, they tend to have a higher expense ratio than other ETFs and limited diversification if investors invest in just single-sector ETFs.  

10. Actively managed ETF

Actively managed ETFs are a type that has an appointed manager and team to make all the decisions related to the fund’s investment strategy. Actively managed funds, as the name suggests, actively managed ETFs involve very active investment strategies, unlike the passive approach that most ETFs adopt. Actively managed ETFs track a benchmark index, but the fund managers have the right to exercise their judgment and deviate from the index. Investors invest in actively managed ETFs to benefit from the expertise of the financial professionals who manage the fund. The active investment strategies these ETFs adopt to enhance the returns gained from the funds. The main advantages of actively managed ETFs include lower expense ratios compared to mutual funds and management and investment strategy implementation by financial experts. However, compared to other ETFs, the expense ratio for actively managed ETFs is higher. 

Apart from these nine main types of ETFs, there are also other types, such as bond ETFs, index ETFs, foreign market ETFs, style ETFs etc. The most commonly used type is equity ETF, and the one with the highest expense ratio is the actively managed ETF. All types of ETFs have pros and cons, and it is up to the investor to opt for ETFs depending on their investment requirements. 

Which Type of ETF is best? 

Choosing the best type of ETF depends on your investment goals and risk tolerance. Some of the most popular ETFs include broad-based index ETFs, sector-specific ETFs, and bond ETFs. Broad-based index ETFs provide exposure to a wide range of stocks, making them a great choice for investors who want to diversify their portfolios. Sector-specific ETFs are more focused on a particular industry, providing more targeted exposure. Bond ETFs invest in fixed-income securities, providing a lower-risk option for investors. Ultimately, the best type of ETF for you will depend on your financial objectives and preferences, so it’s important to do your research and consult with a financial advisor before making any investment decisions.

Which type of Exchange-Traded Funds (ETF) should I choose?

Investors must choose ETFs depending on their investment goals and investment strategies. For instance, they must choose an actively managed ETF if they require the expertise of a financial expert in managing the fund. Investors must choose commodity ETF, currency ETF or bond ETF if they want to diversify their investment portfolio beyond equities. 

What Is an ETF Account?

An ETF account is a brokerage account that allows investors to buy and sell exchange-traded funds (ETFs). ETFs are similar to mutual funds, but they trade like stocks on an exchange. An ETF account gives investors access to a wide variety of ETFs, which can be used to build a diversified portfolio. Investors can buy and sell ETFs throughout the day at market prices, making them a flexible and convenient investment option. ETF accounts may also offer additional features such as commission-free trades, low expense ratios, and tax efficiency. As with any investment account, it’s important to carefully consider your financial goals and risk tolerance before opening an ETF account.

Do you need an ETF Account to be able to Trade ETFs?

Yes, you need an ETF account to be able to trade ETFs. An ETF account is a brokerage account that allows investors to buy and sell ETFs, just like a traditional stock trading account. Most online brokers offer ETF trading, and investors can open an ETF account with any of these brokers. It’s important to carefully research and choose a broker that meets your trading needs and offers low fees and commissions. it’s important to carefully consider your financial goals and risk tolerance before making any investment decisions, including trading ETFs.

How to Buy Exchange-Traded Funds (ETF)?

There are five main steps to buying Exchange-Traded Funds, which are listed below. 

1. Open a trading account.

The first step to buying an ETF is open a trading account. Trading accounts are online accounts that allow investors to buy and purchase securities. Trading accounts can be created with any brokerage of the investor’s choice. Trading accounts are connected to the investor’s bank account and demat account. Demat accounts are dematerialized accounts that hold securities. Once a trading account is open, investors can buy any preferred ETF. 

2. Search for a Platform for Investing

The second step in buying ETFs is searching for a platform for investing. Different platforms available from various brokerages allow investors to open trading accounts. Both online and traditional offline brokers are available for investors. While traditional brokers offer complete services, including personalized advice and market research, online brokers only facilitate the trading process. Through these platforms, investors can search, buy and sell ETFs or other financial securities for investing. Examples of platforms in India include ICICI Direct, IIFL Securities, HDFC Securities etc. 

3. Examine ETFs

The third step to buying ETFs is examining the available ETFs. Using the tools offered by the trading platforms, investors can search for different types of ETFs for investing. Investors examine ETFs based on their investment goals and their diversification requirements. For instance, investors can pick an ETF like HDFC Nifty 50 or ICICI Prudential Nifty 50 if they want to track a stock index fund and hold a basket of equities from the top 50 companies. Investors must look for commodity and gold ETFs to diversify their portfolios beyond equities. Investors seeking financial professionals’ expertise in managing the fund must opt for actively managed ETFs. 

4. Think about a Trading Strategy

The fourth step to buying ETFs is deciding on a trading strategy. After weighing the investors’ investment goals and risk appetite, a trading strategy is decided upon. For example, investors who wish to hedge against risk often opt for commodity ETFs. Commodity ETFs are designed to diversify investment portfolios. Commodity ETFs form a safety net when the equities and debt security markets are down. Investors can use inverse ETF if the market is on a decline. 

5. Set up the trade

The fifth and final step to purchasing ETFs is setting up the trade. Through the trading account, investors can buy or sell ETFs. The charges for the purchase are charged to the bank account that is linked to the trading account. 

Following the five main steps, investors can easily purchase and trade ETFs. Market research and strategizing investments based on each investor’s investment goals and risk appetite can help investors to maximize their returns from ETFs. 

What is the difference between Online Brokers vs Traditional Brokers for ETFs?

The three main differences between online and traditional brokers are listed in the table below. 

Online brokers Traditional brokers 
Online brokers only facilitate the trade through the trading account. Other than facilitating the trade, they also provide advisory services. 
Investors opting for their services must undertake self-market analysis. Investors opting for traditional brokers need not undertake any market research by themselves. Traditional brokers undertake market research for the investors. 
Online brokers do not provide any personalized services for their clients. Traditional brokers provide personalized services for their clients. 

What are examples of the Exchange-Traded Funds (ETFs) Market?

Examples of exchange-traded fund markets include stock markets, bond markets, commodities markets, and forex markets. 

What are the benefits of Exchange-Traded Funds (ETF)?

The five main benefits of ETFs are listed below. 

1. Transparency

One of the main advantages of using ETFs is that they are transparent. Transparency refers to the openness and honest manner in which a fund is managed.  ETFs are designed to track an index, which makes them very transparent. Most ETFs also report their holdings daily, which adds to their transparency. On the other hand, mutual funds and hedge funds report their holdings typically only quarterly. 

2. Costs

The transaction cost of ETF and the expense ratio is less, especially compared to similar securities such as mutual funds. The expense ratio refers to the amount of money charged from investors for fund maintenance and operation. Compared to mutual funds, the expense ratio for ETFs is much lower. The lower transaction cost for ETFs is mainly due to their exchange-traded nature. 

3. Trading

The most important of ETFs is their trading feature. ETFs can be traded through exchanges as quickly as stocks. Unlike mutual funds, which can be traded only once a day, ETFs can be traded anytime during the day. ETFs also involve only a few broker commissions, requiring only a single transaction to buy or sell them.  

4. Taxation 

The taxation benefits offered by ETFs are another main advantage of ETFs. ETFs are more tax efficient than mutual funds as they can avoid short-term capital gains, which are more heavily taxed. 

5. Diversification 

ETFs also help in the diversification of the investment portfolio by including a basket of securities. Diversification refers to the spread of the investment across different financial securities. Diversification helps to hedge against risk. ETF investments can be made in different securities as well, including forex, equities, bonds, commodities etc. 

Other benefits of ETFs include the availability of sector-specific ETFs, inverse ETFs and factor ETFs, which are all designed to maximize returns according to specific market conditions and investor preferences. 

What are the disadvantages of Exchange-Traded Funds (ETF)?

The four main disadvantages of ETFs are listed below. 

  1. Illiquidity: Illiquidity is one of the main disadvantages of ETFs. Liquidity refers to the ease with which financial security can be traded. For ETFs, the bid-ask spread is huge, so investors often do not get the asking price they ask for. Equity ETFs, which are the most common type of ETFs, are also more illiquid than the individual stock that the ETF is comprised of. 
  2. Expense ratio: The expense ratio of most ETFs is low. However, ETFs, such as actively managed ETFs, have high expense ratios. 
  3. Limited diversification: ETFs, which are focused on a single sector or industry, offer limited diversification. 
  4. Settlement dates: ETF settlements are not closed for two after the transaction is complete. The delayed settlement can create delays in reinvestment as the capital is unavailable until two days are over. 

Other disadvantages of ETFs include variances in the index caused by technical issues, exposure to unfamiliar asset classes etc. 

How is an ETF different from a Stock?

An ETF is a basket of financial securities based on the index that it is tracking. For instance, an ETF that tracks Nifty 50 includes stocks from all 50 companies listed on Nifty 50. Investors of ETFs do not own the stocks in the 50 companies. Instead, they only own shares of ETF. The ETF provider owns the stocks that are a part of the ETF. Stocks, however, signify ownership in the company issuing the stock. Investors who purchase stocks have ownership rights over the stock they purchase. 

Why invest in Exchange-Traded Funds (ETFs)?

Investors invest in Exchange-Traded Funds primarily for two main reasons. Firstly, ETFs include most benefits that mutual funds offer at much lower costs. The expense ratio of ETFs is lower than mutual funds, but they provide a diversified portfolio similar to mutual funds. ETFs also track indices, which makes them transparent and easy to understand. Secondly, ETFs are more accessible to investors since they are traded on exchanges like stocks. The trading restrictions for mutual funds, such as being allowed to be traded only once a day, do not apply to ETFs, making it easier for investors to buy and sell them. ETFs have unique advantages and can be suitable for beginners and veterans. ETFs are a good investment option depending on the investors’ investment goals. 

Are ETFs suitable for beginners?

Yes, ETFs are suitable for beginners as long as they closely follow the steps to investing in ETFs. The main advantage for beginners is that most ETFs adopt a passive investment strategy which is easy for someone new to investing in the financial market. ETFs are also more transparent, making it easier for investors to follow up and start trusting the financial markets and their investing process.  

Are ETFs better than stocks?

Both ETFs and stocks have their pros and cons. Each investor has to decide which to invest in, depending on their investment goals and risk tolerance. While ETFs offer more opportunities to invest in a diversified portfolio, stocks provide more liquidity. ETFs involve expense ratios, whereas stock investments do not have an expense ratio. Therefore, each investor has to choose the best security for them. 

Is ETF a Good Investment?

ETFs are a good investment for investors depending on their investment goals and risk tolerance. ETFs offer different investment options across various asset classes that cater to different investors’ requirements. Prior market research, analysis, and investment strategies can ensure that investors make good returns from ETFs. 

Can ETFs make you rich fast?

ETFs can provide investors with good returns depending on the type of ETF invested. However, investors must consider their investment goal, market conditions and risk tolerance before investing in ETFs. Each type of ETF is designed differently to use different market conditions. For example, inverse ETFs can provide good returns in a declining market. Actively managed ETFs use the expertise of financial experts who take over fund management. Therefore, the returns made through ETF depend on the choices made by the investors. 

Are ETFs Index Funds?

Yes, ETFs are index funds tracking a bundle of securities. The indices that ETFs track be stocks, bonds, commodities, or foreign exchange. ETFs can also be designed to track the index of a specific sector, such as energy, technology, healthcare etc.

What is the difference between ETF and Index Funds?

The main difference between ETFs and Index Funds is that ETFs are traded any time of the day, similar to stocks. On the other hand, index funds are sold only once at the end of the trading day when the price is fixed. 

What is the difference between ETF and Mutual Funds?

There are primarily two main differences between ETFs and Mutual Funds. Firstly, ETFs can be traded through an exchange throughout the day. On the other hand, mutual funds are traded only once at the end of the trading day. Secondly, most ETFs are passively managed and involve a smaller expense ratio. On the other hand, mutual funds are actively managed investment funds that involve a high expense ratio.  

Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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