Exchange traded funds (ETFs) are investment products that track an index, market sector, commodity, or asset class. These ETFs trade like stocks on stock exchanges.
An Exchange Traded Fund (ETF) is offered by a fund company and designed to track and replicate an underlying index or benchmark. An index is a type of portfolio that tracks the performance of a particular market, industry or economy. Examples of indices include Dow Jones Industrial Average, S&P 500, FTSE 100.
The fund shares are bought and sold much like normal securities, except they are bought and sold at a price quoted by an exchange. An example of an exchange is NASDAQ. When people hear about ETFs, many think of mutual funds that invest in individual companies. However, that's not what we're talking about here. In fact, these funds are based on indexes like the S&P 500 Index or the Dow 30.
There are two general types of ETFs - passive and active. Active ETFs tend to have higher fees than passive ones. Most providers offer both, but their prices may vary. Passive ETFs try to match the returns of a particular index without making any changes to the index. For example, if the S&P 500 is currently up 10%, then a passively managed SPDR S&P 500 ETF would keep its holdings, but the fund doesn't make any trades. If the market were down 20% and the same fund was trading at $25 per share, the fund manager wouldn't buy back any shares. Instead, the fund would stay exactly where it is until the market recovers and moves toward the original target level.
Passive ETFs are often referred to as tracker ETFs. There are various types of passive ETFs. One of them is called a leveraged ETF. Leverage means using borrowed money to increase investment returns. With leveraged ETFs, investors borrow money to purchase the assets being tracked. As long as the markets don't fall, the leveraged ETF will return more than the cost of borrowing the money. Unfortunately, leverage creates additional risk along with its potential rewards.
Active ETFs, on the other hand, actively manage the investments. That involves buying and selling securities to move the fund closer to the benchmark. Many active managers make use of quantitative techniques to try and predict the future movements of the markets. These techniques may include computerized algorithms, models, technical analysis, fundamental analysis, etc.
In addition to tracking returns, some ETFs provide dividends, interest payments or even capital gains distributions.
A good way to learn about different ETFs is to check out the website of the fund company. You'll find charts, descriptions, links to other information on the subject and videos that explain how each ETF works.
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