What is ETF?

An ETF (exchange-traded fund) is an exchange-traded fund that holds securities based on an index, market sector, commodity, or any other asset class.

The principle of operation of exchange-traded funds is based on the fact that some investment companies create a unit that buys several assets into its portfolio according to a strategy they define. They usually replicate the structure and proportions of well-known market indices:

• S&P,
• Dow Jones,
• Nikkei and others.

Then, ETF issues units, which are analogous to shares of companies, the right to own a share of the total capital of the entire fund. Such units are freely traded on the exchange along with stocks and bonds, hence the very name of these funds.

Within one such ETF, there can be hundreds of stocks from different industries and one single commodity or asset. In the case of the notorious Bitcoin ETFs, the capital is formed only from bitcoin. The essence of such funds, which include only one asset, is to provide simplified access to specific assets — minerals, agricultural products, cryptocurrencies, etc.

In general, buying units in an exchange-traded fund allows an investor to invest at once in an extensive list of securities included in an index without having to make regular adjustments to the shares in his portfolio and save up for expensive shares for a long time. This increases diversification and reduces risks without resorting to complex schemes and borrowing. It can also be cheaper than assembling an investment portfolio on your own due to the reduction of many trading commissions.

For example, just one share of Booking stock is worth about $3500 at the beginning of 2024. For an investor to include these stocks in their portfolio with a stake of no more than 10%, the portfolio's total value must be more than $35000. This is a considerable sum for the average investor, making Booking shares virtually inaccessible. This is where ETFs become useful — any investor can buy a unit of a conditional ETF on the S&P index for $200, thus buying a share in a hundred of the most prominent American companies, including Booking.

There are also investment funds that pay dividends to their unit holders.

Pros of exchange-traded investment funds:

• ETFs diversify risk by tracking companies in an entire sector, country, or industry.
• Buying ETFs does not require special knowledge or professional qualifications.
• If you buy them individually, ETF share prices are much lower than the cost of the same set of securities.
• ETFs give access to "preferred" or exotic assets. For example, many bonds are available only in large packages, and raw materials like gold or oil are almost impossible for a private person to purchase without insurance and storage costs.

Minuses of exchange-traded investment funds:

• Investing in exchange-traded funds, like stocks, does not guarantee a return.
• Investments in ETFs are not insured.
• Part of the profit goes to the manager's commission. The service cost is deducted from the total value of assets held in the fund. As a rule, it is within 1% per annum of the total value of the entire fund under management, regardless of the returns shown for that period.

Conclusion

To summarize, ETFs help to "keep your eggs in one basket" and remove some of the routine portfolio management tasks from the investor while saving on trading commissions.

In addition, exchange-traded funds can lower the entry threshold thousands of times than if an investor were to build a portfolio independently from individual assets in the fund's portfolio.

And sometimes, as in the case of Bitcoin ETFs, they allow you to access exotic assets right in the traditional financial market.