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Michael Mosi

Introduction to ETFs: What is an ETF?

A type writer machine holding a sign with ETF word

What is an Exchange-Traded Fund (ETF)?

 An ETF is a type of investment fund traded on the stock exchange. It combines the diversification of assets in mutual funds and the convenience of trading in the stock exchange into one fund. They are designed to track the performance of a specific index of an asset such as stocks, bonds, or commodities.


This means they aim to replicate the returns of these benchmarks as closely as possible. This is one of the main reasons ETF investments are attractive; they reduce market volatility risks and increase your earning potential. They are also attractive because compared to traditional funds, ETFs offer lower fees and increased liquidity. Some key factors to consider when evaluating ETFs are fees, liquidity, and portfolio fit.


How do ETFs work?

An ETF works by pooling various assets such as stocks, bonds, commodities, or currencies into a basket. Once all these multiple assets are pooled into a basket the ETF provider issues shares in the fund and makes them available to investors. This aspect of ETFs is what makes them similar to mutual funds that also pool various assets.


Once the shares are made available to investors they can be bought and sold on exchanges much like individual stocks. This means investors can trade ETF shares on the exchange throughout the entire trading day.

There are various types of exchange-traded funds, each designed to serve different investment goals. Some common types of ETFs are:

 

  • Passive ETF: Passive ETFs mirror the performance index of a broader index, be it a diversified index like the S&P 500 or a more specialized sector.


  • Actively managed ETF: These ETFs have portfolio managers who make decisions about which securities to include in the portfolio rather than replicating an index or sector. 


  • Bond ETF: Bond ETFs are used to provide consistent income for investors. The distribution of profits depends on the performance of underlying bonds such as government or corporate bonds. A unique attribute bond ETFs have is they do not have a maturity date. This provides investors with ongoing exposure to a diversified portfolio of bonds without the need to manage the maturity and reinvestment of individual bonds. 


  • Stock ETF: This is a group of stocks that track a single industry or sector such as technology or oil. This is done to offer exposure to a particular industry that encompasses both established leaders and emerging companies poised for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.


  • Industry ETF: These funds focus on particular sectors or industries. For example, a tech ETF will focus on companies operating in that sector.


  • Commodity ETF: Investing in commodities such as coffee and gold through commodity ETFs can diversify a portfolio. It makes it easier to mitigate losses during market downturns.


  • Currency ETF: These ETFs follow the performance of currency pairs consisting of domestic and foreign currencies. They are used to forecast currency price movements driven by political and economic factors in a country.


How do ETFs compare to Mutual funds?

Mutual funds are investment funds that pool money from many investors. This fund is then managed by a financial professional who invests the money into a basket of assets and securities. As much as mutual funds offer good returns, in most cases, you can’t trade them like stocks.


ETFs on the other hand offer the best of both worlds. They expose investors to a diversified portfolio of assets and allow them to trade these assets on the stock exchange just like stocks. Another key difference between mutual funds and ETFs is that ETFs do not aim to beat the index but match its performance. This will potentially give the investor more predictable returns.


Advantages of investing in ETFs

  1. Diversification: One of the biggest advantages of investing in ETFs is investors can create a diversified portfolio that covers a wide range of asset classes. This helps spread your investment risk across different companies, industries, and geographical locations.

  2. Liquidity:  You can easily buy and sell ETF shares at market prices whenever the market is open because they are traded on the stock market.

  3. Cost-effectiveness:  ETFs allow you to invest in a whole index or a specific sector with just one trade instead of purchasing individual stocks. This means you will have a lower transaction cost. 


Risks of investing in ETFs

  1. Higher Fees for Actively Managed ETFs: Actively managed ETFs come with a higher fee compared to passive ETFs. This is because of the increased cost that comes with frequent trading and active management strategies.

  2. Limited diversification in Single-industry ETFs:  ETFs that are focused on a specific industry or sector provide targeted exposure to a particular market segment. They also expose the investors to the risks associated with that industry, sector, or market segment. Therefore if the sector underperforms the entire ETF can suffer.

  3. New options:  The ETF market constantly introduces new products, but investors should be very cautious with them. It is crucial to analyze marketing materials, understand the strategy of the underlying index, and be wary of back-tested returns.

 

ETFs are a versatile and attractive investment option. This is because they offer a way to invest in a broad range of asset classes, including stocks, bonds, commodities, and currencies while providing the flexibility of trading like individual stocks. Compared to mutual funds, ETFs often have lower fees and greater liquidity, making them a popular choice among investors. However, it's important to consider the specific type of ETF, its fees, and whether it aligns with your investment goals.


Ndovu, an investment platform in Kenya, provides a user-friendly app that offers strategically curated ETFs, allowing you to invest in a diverse basket of assets. With Ndovu, you can benefit from the advantages of ETFs while ensuring your investments are tailored to your financial objectives and risk tolerance.


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