Exchange-Traded Funds also known as ETFs for short are one of the most popular investing options today. ETFs have been popular among investors throughout the world because to their numerous advantages, including simple diversification, cheap fees, and strong tradability.

ETFs have two key qualities that distinguish them: they are funds and they are exchanged on an exchange. In this guide, we unpack what this means by looking into what is a fund, how to identify ETFs, what are the risks that come with ETFs and more.

Exchange-Traded Funds defined

An ETF is an investment vehicle that baskets securities together like a mutual fund, offering built-in diversification and professional management and are listed and traded on stock exchanges. This feature provides investors with several advantages, including the ability to purchase and sell ETF shares quickly and conveniently during market hours.

Breaking down ETFs: What is a fund?

Funds, like a company stock, are a sort of financial vehicle that investors may purchase shares of. In reality, all ETFs are open-ended (or continuously distributed) investment trusts, which means that new units can be established and redeemed at any time. Because a fund is a pooled vehicle made up of a variety of underlying firms, geographies, and asset classes, investors are not purchasing direct ownership in a company like they would with a regular stock. Funds simply take money from investors and invest it in accordance with the fund's investment goal.

Two types of ETFs: Active and Passive ETFs

ETFs are commonly categorized as investment vehicles that gain access to broad, passively managed equity indices. They have evolved over time to track all major investment asset classes, categories, industries, sectors, and geographies, and can be both passive (index tracking) and actively managed.

Active ETFs have an objective of beating the performance of some benchmark. Some ETFs incorporate rules-based or “smart beta” investing strategies, as well as passive index tracking capabilities. There are also many varieties of ETFs that will help you invest in a specific region, for example Europe, Asia-Pacific or Latin America. Other ETFs target a sector, for example technology, while others target up-and-coming themes like psychedelic medicine, or cloud computing.

Diversify your portfolio with ETFs

ETFs can help you buy hundreds of stocks in one transaction. ETFs are useful for investors who don't want to put all their eggs in one basket since they can hold multiple securities. Since ETFs can be purchased and sold on the stock exchanges, investors can trade quicker. Let's assume you believe green energy is a solid investment, but you're not sure which specific stocks to purchase. A green energy ETF allows you to spread your investment among a number of firms participating in the green energy industry.

Buying a fund instead of each individual stock has many advantages for investors such as portfolio diversification - a basic principle of investing to manage risk. In simple terms, it means that you should not put all your eggs in one basket. In investing terms, this means investing in many different companies, asset classes, and sectors.

How are ETFs named globally?

When looking at the 7,000+ ETFs accessible throughout the world, it's easy to become lost. ETFs, on the other hand, have the same name standard across the world. In this section we break down how ETFs are organized.

ETF names often start with the name of the ETF Issuer. The ETF Issuer is an asset management company that creates, sells and markets ETFs.

Then if the ETF is passive and tracks an index, the index provider name may be included. Index providers are companies that design and calculate indexes.

The name of the actual index follows the index provider name. The index name can include a number, such as the number of securities tracked by the index (such as the S&P 500 or FTSE 100). Or, it can indicate a geographical focus or any other characteristics of the securities included in the index (like MSCI Emerging Markets or MSCI World Small Cap).

More information about an ETF may be found towards the end of the name. Those details can include:

• Share class dividend policy (distributing or accumulating)
• Hedging policy for foreign currency exposures (hedged or not)
• Currency of the fund (the currency in which the share price is stated officially, such as USD).

What makes ETFs popular with investors?

ETFs are known for their 4 key benefits: tradeability, diversification, transparency, liquidity, and low costs.

Tradability

An ETF's real-time market price fluctuates throughout the trading day in tandem with the prices of the assets it owns. ETFs can be purchased or sold at any moment the exchange is open, allowing traders to profit from short-term price fluctuations. Mutual funds, on the other hand, only trade once a day, after the market has closed.

Diversification

With the multitude of ETF options available in Canada, they can be used to combine equity with other asset classes, to create low correlation and risk reduction effects.

Transparency

The price of an ETF may be seen on all major data distribution platforms as well as most online trading websites during regular market hours. Mutual funds, on the other hand, aren't priced until the end of the trading day, so you won't know the price until you've made your order.

Liquidity

The ability to purchase and sell ETF units is supported and maintained by the ETF's lead designated market maker. The market marker guarantees that there is an adequate supply of units for investors to buy and sell by placing bids and asks on exchanges.

Low Costs

ETFs, like mutual funds, contain management fees, although they are less expensive than traditional mutual funds. You also don't need a lot of money to get started because an ETF's minimum investment is the cost of a single share, which may be as low as $5, whereas mutual funds may demand a minimum investment of $500 or more.

Why ETFs are known to be tax efficient?

ETF Issuers can design an ETF in a way that maximizes tax efficiency for investors. This is achieved by the ETF provider when they create the ETF. ETF providers can utilize parameters including replication approach, income treatment, fund domicile, and tax statuses to improve the tax efficiency of their products.

What are the risks that come with ETFs?

Mutual funds and ETFs are subject to the same risks as any other financial market, including the type of individual securities in which the fund invests, and the investment strategy pursued by the fund management. While ETFs provide numerous benefits to investors, they aren't a magic wand that assure profits. ETFs, like other investments, have the potential to lose value, and you should be aware of the following risks before purchasing one:

Capital risk

The value of an ETF, like other financial products, might change. Not all ETFs are suitable for all investors. The value of the investments may rise or fall, and the investor may not get the whole amount invested initially.

Tracking risk

Even once fees are taken into account, ETFs may not perfectly track an index. The gap between the ETF's return and the index's return is known as 'tracking error.' 'Tracking risk' refers to the variation (standard deviation) in daily excess returns between the ETF and the index.

Income risk

The income associated with a distributing ETF share class is not fixed and may fluctuate.

Currency risk

Exchange rate fluctuations might influence ETFs exposed to foreign currencies. This implies that fluctuations in the value of foreign currencies might affect the value of ETF units purchased and sold in those currencies. An American investor who buys an ETF that invests in Japanese equities, for example, will see the value of their ETF fluctuate if the price of the stocks or the USD/Yen exchange rate changes.

Taxation risk

Depending on the investor's financial status, the amounts and bases of taxes, as well as tax reliefs, might fluctuate.

There may be other risks that are specific to the exposure of an ETF and its underlying holdings – for example broad market risk, sector risk, or credit risk. Each ETF issuer specifies such risks in the ETF’s prospectus which can be found on their websites. Investors should refer to the ETF documentation before investing in the ETF.

*This article was written in collaboration with Trackinsight.