I am Dani from Wealthmakr and today I would like to explain what an ETF is. It will be just a quick overview and on the bottom of this article we wil have further information.
Exchange Traded Funds are securities that move like an index and thus reflect it.
Unlike other index products, they have a very low tracking error. This means a small deviation from the index.
What is the difference between a ETF and a investment fund?
ETF’s are traded daily on the stock exchange, similar to shares. This distinguishes them a bit from investment funds, which are usually traded through the investment company.
An index fund is a passively managed product in which the fund manager does not engage in stock picking. This means that the fund manager does not pick individual stocks.
The adjustment usually takes place via a computer system that acts automatically and thus saves costs.
How is an ETF created?
The creation of an ETF can take place in different ways.
One of these ways is physical mapping.
In physical mapping, a company is formed that physically buys the securities.
This means that the value of the company fluctuates just as much as the value of the securities it contains.
In order to make this movement available to investors, this company in turn issues the ETF share. You have to think of it as shares.
These securities, i.e. ETFs or shares, then move exactly like the value of the company. Thus the index is accurately reflected.
Are there different types of ETFs?
There are many different types of ETFs. For example, the indices or reflect sectors or commodity ETFs or countries or regions ETFs.
Two special forms of ETFs are short and leveraged ETFs.
A short ETF moves in exactly the opposite direction to the index.
For example, if we take the Dow Jones as an index that falls 2 percent, this means that a short ETF rises by 2 percent at the same time.
Conversely, if the Dow Jones rises by 2 percent, the short ETF would fall by 2 percent.
A leveraged ETF participates disproportionately in profits and losses.
That means if we take a Dow Jones-ETF with a leverage of 2 on the Dow Jones and the Dow Jones increases by 2 percent, my ETF profits 4 percent.
However, if the DOW JONES falls by 2 percent, my ETF falls by 4 percent.
So we profit disproportionately and also lose disproportionately.
What are the advantages of an ETF?
The biggest advantage of an ETF is its diversification, or rather the distribution of money across different sectors, countries or securities.
This minimizes the investment risk.
The physical mapping of an ETF has the advantage that there is no risk for the issuer as is the case with certificates, for example.
For example, if you buy an ETF on the Dow Jones that was issued by Chase Bank, you will not make any losses even if Chase Bank goes bankrupt.
You only lose if the Dow Jones falls.
However, these advantages also apply to investment funds. The advantage of ETF’s over investment funds is that they are – as already mentioned at the beginning – usually much cheaper.
This is because ETFs are passively managed and, unlike investment funds, there is no need to pay for active fund management.
The fund manager at the ETF only tracks the index once and only has to act when the index changes.
Let us stick to our Dow Jones example: If a company such as Chevron, for example, leaves the Dow Jones and another company moves up into the Dow Jones in return, the fund manager must act.
We hope this overview has helped you to get a better understanding of ETFs. If you want to know more about ETFs, you can find useful information HERE.
If you want to know more about making money long term and legit, have a look at our Article How to get out of the trap of the 9 to 5 scam.