Exchange-traded funds (ETFs)

Definition

Exchange-traded funds (ETFs) are investment funds that trade on stock exchanges, much like individual stocks. They hold a diversified portfolio of assets, such as stocks or bonds, and provide investors with a way to gain exposure to a variety of securities without having to purchase each one individually. By offering diversification and liquidity, ETFs are an important tool in managing portfolio risk and achieving investment goals.

5 Must Know Facts For Your Next Test

1. ETFs typically have lower expense ratios compared to mutual funds, making them a cost-effective option for investors.
2. Investors can buy and sell ETFs throughout the trading day at market prices, which provides greater flexibility than traditional mutual funds that are only priced at the end of the trading day.
3. ETFs can be designed to track specific indices, sectors, commodities, or even investment strategies, allowing for tailored investment approaches.
4. Many ETFs pay dividends to investors based on the income generated from the underlying securities they hold.
5. Because they offer built-in diversification by holding a range of assets, ETFs can help mitigate risk in an investor's portfolio.

Review Questions

• How do exchange-traded funds contribute to diversification within an investment portfolio?
  • Exchange-traded funds contribute to diversification by allowing investors to hold a collection of different securities within a single fund. This means that instead of investing in individual stocks or bonds, investors can spread their capital across various assets with one purchase. As a result, if one security underperforms, others within the ETF may balance out the overall performance, reducing the risk associated with investing in any single asset.
• Discuss the advantages and disadvantages of using exchange-traded funds compared to traditional mutual funds for portfolio management.
  • Exchange-traded funds offer several advantages over traditional mutual funds, including lower expense ratios and the ability to trade throughout the day at market prices. However, one disadvantage is that ETFs may incur brokerage commissions when buying and selling shares. Additionally, while ETFs provide diversification benefits, their value can fluctuate throughout the trading day based on market conditions. Investors need to weigh these factors carefully when deciding which investment vehicle suits their portfolio management strategy.
• Evaluate the impact of exchange-traded funds on overall market liquidity and volatility in financial markets.
  • The rise of exchange-traded funds has significantly impacted market liquidity by increasing trading volume and allowing for easier access to various asset classes. However, this increased liquidity can also lead to greater volatility during market downturns as large volumes of ETF shares are traded rapidly in response to investor sentiment. The interconnectedness of ETFs with underlying securities means that sharp movements in ETF prices can influence the prices of the assets they hold, potentially amplifying market fluctuations during periods of stress.

Related terms

Diversification: The practice of spreading investments across various financial instruments, industries, and other categories to reduce risk.

Mutual Funds: Investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities, but they do not trade on exchanges like ETFs.

Index Fund: A type of mutual fund or ETF designed to track the performance of a specific index, such as the S&P 500, providing broad market exposure.