What are ETFs and How Do They Work?

Andrew Moran
By Andrew Moran
Edited by Taj Schlebusch

Published April 23, 2021.

What are ETFs and How Do They Work? main image

Exchange-Traded Funds (ETFs) have become hugely popular in recent years, enabling investors to build diversified portfolios. So this article we're going to explain just what ETF contracts represent, and how they work in practice.

A ‘Basket’ of Commingled Assets

ETFs effectively represent what is referred to as a ‘basket’ of commingled assets. Instead of simply investing in a single stock, investors can draw together several different assets that they believe have value, and invest in them collectively.

While several different trading strategies are possible with ETF contracts, they particularly appeal to day traders. ETF shares are traded throughout the day, at prices that rapidly vary depending on supply and demand.

ETF Contracts

There are several different types of ETF contracts available, with some attempting to diversify equity and others promising larger returns. Originally, ETFs were organized as unit investment trusts, and were based on a fixed portfolio of securities.

Today, ETF contracts are extremely flexible and can be considered somewhat bespoke. The open-ended structure of ETF contracts means that dividends can be reinvested immediately, therefore this approach to the stock market often finds favor with institutional investors.

Advantages ETF Contracts

Advantages of ETF contracts include the potential tax efficiency and the lower expense ratios associated with the investment. There is no minimum currency amount associated with ETF investments, and this means that they can often provide an entry-level option for new investors.

Increased leveraging is also possible with ETFs, this means that investors can make more money with less initial investment. They can also be sold short; meaning that investors can effectively bet against the group of assets, claiming that they will decline in value.

ETFs Core Popularity: Flexibility

The flexibility of ETFs means that they tend to encourage frequent trading, and this has been the core of their popularity. ETFs have become a central part of the stock market, particularly over the last few years.

An Explosive Industry

The ETF market has exploded in recent years, totalling nearly $9 trillion, from the $500 billion value in 2005. Although ETFs are still behind the $41 trillion that mutual funds possess in assets, these investment vehicles have more money than index-tracking mutual funds. Considering how appealing ETFs are for both seasoned and novice traders, this figure will continue to balloon as time goes by.