Exchange-traded funds, better known by the acronym ETFs, provide investors with the advantages of both stock trading and the diversification benefits associated with mutual funds. Exchange-traded funds are investment funds that are traded on stock exchanges and offer several advantages over mutual funds.

What are exchange-traded funds?

ETFs are a type of fund that usually only holds one type of security. A bond exchange-traded fund, on the other hand, holds bonds, while a stock Exchange-traded fund holds stocks. People who buy an ETF share own all of the stocks or bonds in the fund. Say an ETF held 50 stocks. The people who owned the fund would have a very small stake in each of those 50 stocks.

Most exchange-traded funds are passively managed, which means that the fund holds a set number of stocks based on an index of investments that has already been chosen. Many mutual funds, on the other hand, are actively managed, which means that professional investors try to pick the investments that will go up and down in value.

Advantages of Exchange-traded funds over Mutual Funds

Exchange-traded funds are flexible investments for asset allocation, diversification, and market tracking performance with low fees and tax efficiency (Tse, 2008) (Tse, 2015).

They offer high liquidity and low transaction costs, making them an attractive option compared to traditional index funds (Liebi, 2020).

Exchange-traded funds have seen rapid growth in trading volume and product coverage, reflecting increasing demand for passive investments (Tse, 2008) (Liebi, 2020).

Impact of Exchange-traded funds on Market Liquidity

Studies have analysed the effect of ETFs on liquidity, price discovery, volatility, and comovement of underlying securities. Exchange-traded funds have been found to provide high liquidity and impact market volatility (Liebi, 2020).

The tendency of ETFs to trade at a premium to net asset value (NAV) and the life-cycle pattern in premiums can be explained by liquidity segmentation. ETFs with larger NAV tracking error standard deviations tend to trade at higher premiums, indicating the value of liquidity benefits offered by Exchange-traded funds (Piccotti, 2018).

What are the main types of Exchange-traded funds?

There are different kinds of ETFs to meet the wants of investors. When investors buy Exchange-traded funds, they divide the market into different industries, financial themes, prices, and other factors that investors care about.

Here are some of the most common types of Exchange-traded funds and what they hold:

• Equity Exchange-traded funds – Equity ETFs monitor a stock index. You may select ETFs that encompass major enterprises, small enterprises, or equities from a certain nation. Equity ETFs enable investors to focus on industries that may be performing favourably, such as technology or finance, rendering them a favoured option..
• Bond / Fixed Income Exchange-traded funds – These are standard ETFs intended to offer exposure to several categories of bonds. Investing in bonds effectively mitigates market volatility and enhances portfolio diversification..
• Index Exchange-traded funds – Index funds monitor the performance of their respective underlying index. They are additionally categorised into replication and representational ETFs. Replication ETFs are index funds that exclusively invest in the securities that comprise the index. Conversely, representative ETFs allocate the majority of their fund corpus to representative samples, with the remainder invested in alternative securities such as futures and options.
• Commodity  Exchange-traded funds – ETFs, which are often more difficult to obtain than stocks, provide an excellent means of investing in commodities such as gold, silver, or oil. These present an appealing alternative to equities for enhancing portfolio diversification and mitigating risk. Nonetheless, commodity ETFs may exhibit lower transparency compared to index or equity ETFs. They frequently do not possess the underlying asset, such as gold, but utilise derivatives instead. Derivatives monitor the underlying commodity price but may entail greater risks, such as counterparty risk, compared to an ETF that directly holds the underlying asset.
• Currency Exchange-traded funds – These securities let an investor to engage in currency market operations without acquiring a particular currency. The objective of such investments is to monitor and capitalise on the price volatility of a certain currency or a collection of currencies.
• Inverse Exchange-traded funds – These funds are structured to yield results contrary to those provided by the underlying market index. With these products, share prices fluctuate inversely to the share prices of the inverse ETFs.
• Liquid Exchange-traded funds – These funds aim to mitigate price risks and optimise returns by investing in a portfolio of short-term government securities, including money and money market instruments with brief maturities, while concurrently striving to preserve liquidity.
• Value Stocks Exchange-traded funds – Stocks that appear undervalued in relation to their profits or assets.
• Dividend Stocks Exchange-traded funds – Stocks that offer dividends or possess a robust payout history.
• Country Exchange-traded funds – Equities with significant exposure to a specific nation.

Key Differences Between Exchange-traded funds and Index Funds

Exchange-traded funds are continuously traded on public exchanges, with their prices fluctuating throughout the day based on supply and demand like common stock, while index funds price daily based upon net asset value (NAV) (Browne, 2017).

Exchange-traded funds are more transactionally superior, tax-efficient, and have lower fees compared to index funds, contributing to their success (Buetow Jr & Hanke, 2024).

Regulatory Considerations for Launching an Exchange-traded funds

Growing regulatory concerns have led to responses addressing systemic risk, excess volatility, suitability for retail investors, lack of transparency and liquidity, securities lending, and counterparty exposure (Aggarwal & Schofield, 2014).

There has been a shift toward multiple counterparties, overcollateralization, and disclosure of collateral holdings and index holdings to address these concerns (Aggarwal & Schofield, 2014).

In conclusion, Exchange-traded funds offer several advantages over mutual funds, including flexibility, low fees, and tax efficiency, and have a significant impact on market liquidity. They differ from index funds in terms of trading mechanism and cost efficiency. Regulatory considerations for launching an exchange-traded fund have led to responses addressing various concerns related to systemic risk, transparency, and liquidity.

Important things to remember

• Exchange-traded fund come in a lot of different types, and each one is meant to give you access to a different set of assets and markets.
• Because there are so many Exchange-traded funds, there should be one that fits your risk and return profile.
• You can reach your goal with more than one exchange-traded fund. Some Exchange-traded funds may offer steady returns with lower risk, while others may offer higher returns with higher risk.

Embracing the Future of Investing

Exchange-traded funds have come a long way since their inception, transforming the investment landscape with their unique blend of features. The “Guide to ETFs” provides a comprehensive overview of their evolution, advantages, and strategic nuances. Whether you’re a seasoned investor or just starting, understanding Exchange-traded funds’ full potential can help you make more informed investment decisions.

By delving into lesser-known insights and providing data-backed analysis, this report offers a valuable resource for anyone looking to navigate the world of Exchange-traded funds. As you walk down Wall Street, armed with the knowledge from this guide, you’ll be better equipped to make savvy investment choices and harness the power of Exchange-traded funds to achieve your financial goals.

References

1. Aggarwal, R., & Schofield, L. (2014). The growth of global ETFs and regulatory challenges. In Advances in financial economics (pp. 77–102). Emerald Group Publishing Limited.
2. Browne, R. M. (2017). Exchange-Traded Funds (ETFs) An Overview. The Capital Markets: Evolution of the Financial Ecosystem, 469–480.
3. Buetow Jr, G. W., & Hanke, B. (2024). The Exchange Traded Fund Landscape: Past, Present, and Future. Journal of Portfolio Management, 50(9).
4. Liebi, L. J. (2020). The effect of ETFs on financial markets: A literature review. Financial Markets and Portfolio Management, 34(2), 165–178.
5. Piccotti, L. R. (2018). ETF premiums and liquidity segmentation. Financial Review, 53(1), 117–152.
6. Tse, Y. (2008). Exchange-Traded Funds. In Advances In International Investments: Traditional and Alternative Approaches (pp. 97–108). World Scientific.
7. Tse, Y. (2015). Momentum strategies with stock index exchange-traded funds. The North American Journal of Economics and Finance, 33, 134–148. https://doi.org/10.1016/j.najef.2015.04.003

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1. The Comprehensive Guide to ETFs for 2025: Unveiling the Hidden Gems