An exchange-traded fund (ETF) is an investment fund that holds a collection of underlying assets such as stocks or bonds and trades on a stock exchange throughout the trading day.
How exchange-traded funds work
An ETF pools money from multiple investors to buy a basket of assets. This structure allows investors to buy a single share that represents proportional ownership of the entire portfolio. ETFs trade on international stock exchanges like shares of individual companies. Investors buy and sell ETF shares during regular market hours at fluctuating market prices.
The trading mechanism of an ETF differs from a mutual fund. Mutual funds price once per day after the market closes. ETFs offer intraday liquidity. Authorized participants create or redeem ETF shares to keep the market price close to the net asset value of the underlying assets. This creation and redemption process prevents the ETF share price from deviating too far from the actual value of the assets it holds.
Most ETFs are passive investments that track a specific index or a defined market sector. An ETF might track a broad global equity index or a collection of government bonds. The fees associated with passive ETFs are generally lower than those of actively managed funds because they require less active decision-making by fund managers.
ETFs are available on exchanges worldwide. Regulatory frameworks differ depending on the jurisdiction. European ETFs often comply with UCITS regulations. These rules dictate specific diversification requirements. Elephants building an international portfolio must review their local brokerage access and tax rules regarding foreign ETF holdings.
Example
Suppose you and other Elephants want to invest in the global agricultural sector because of high demand for crops like peanuts. Instead of buying shares in dozens of individual farming companies across different countries, you purchase shares of a global agriculture ETF.
This ETF holds stock in 50 different agricultural firms. When you buy one share of the ETF on your local stock exchange at 10:30 AM, you gain exposure to all 50 companies. If the overall value of those agricultural companies goes up, the value of your ETF share goes up. If you decide to sell your position later that same afternoon, you can do so immediately through your standard brokerage account.