Today we are going to cover the alternative type of investment in the stock market – Exchange-traded Fund. Let’s find out together what is exchange traded fund and how it differs from stock, hedge fund or mutual funds.
As a potential investor, it is very important to know exactly what you are looking for in an investment. “What kind of investment best fits my plan?” is the most important question an investor asks himself before putting in his money. Am I looking for something short term with high-risk high reward? Do I want something that is impervious to the unpredictable swings of the market? Do I want something that builds slowly and assures me the premium gain years after? There are holdings that answer all these questions. Choosing the right security is not so tricky once you know what you are looking for and the behavior of the security chosen. Do your homework.
Answering that question well determines if you put your money in stocks, mutual funds, exchange-traded funds, in rare cases hedge funds or any other form of security.
A stock is a type of security that represents an extent of ownership in a corporation and is a part of the corporation’s assets and earnings. A person who owns stocks is called a Shareholder and the extent of ownership is calculated relative to the total amount of shares sold by the corporation. For example, owning 100 shares in a company that has 500 shares gives you claim to 20% of the company’s assets. Stocks are the oldest form of portfolio investment.
A hedge fund is an investment fund sponsored by particular accredited individuals or institutional investors which with complex portfolio structures and risk-management techniques invest in a particular set of assets. Hedge funds are very distinct from other types of funds and are not available to everyone.
Mutual funds have been around for decades now and are simple ways investors put in their money and watch it grow without going through the strenuous work of managing portfolios that run into hundreds of stocks. Mutual funds are arrangements between a group of investors who band together and employ a professional investment manager to buy and manage securities on their behalf. This manager rations the holdings bought into ratios known as shares and relays the information to the investors. Every investor knows how many shares he has. Therefore if an investor wants to buy or sell shares, he knows how much each share is worth and pays or receives money corresponding to that.
Exchange-traded funds are also mutual funds offering shares which represent a proportional interest in a pool of assets ranging from stocks to bonds, commodities, currencies or a blend of assets. The only difference being that they are exchange-traded. This difference, as simple as it sounds, makes a world of difference and offers exchange-traded funds a flexibility that cannot be found in mutual funds. Exchange-traded funds are simple to own and manage because unlike mutual funds, they are bought directly from any brokerage account. They can be bought and sold at any time of the day and as many times as possible, unlike traditional mutual fund that can only be sold once and only after trading closes.
Exchange-traded funds allow you a variety of managing options impossible with mutual funds. They can be sold short, bought on margin and limits can be placed on them, something called stop-loss orders. Exchange-traded funds come at a lower cost and provide improved tax efficiency. They allow the owner of a traditional brokerage account access to 40 different reaches of the market at low cost.
To learn more about various types of exchange traded fund, read our blog post about ETFs classification.