In this article, the DowExperts will answer the following questions for you:

1. What is an ETF?
2. Why does this market play such an important role in the investment arena?

3. Where do these investment instruments trade?
4. How is the price of an ETF formed?

An Exchanged Traded Fund (ETF) provides investors with the opportunity to invest in a collection of different individual securities grouped together based on different parameters or strategies. The ETF market has continued to grow its popularity and importance, as a major force in today’s investment arena, as it allows small traders as well as large institutional investors to gain exposure to particular sectors in a very liquid and low-cost manner. The ETFs are quite different compared to traditional open-end funds. Traditional open-end mutual fund shares are traded only once per day after the market closes and the trading activity (buying and selling) is only done with the mutual fund company that issues those shares.
Additionally, investors must wait until the end of the day before the fund’s net asset value (NAV) is reported before they could figure out what price they paid for the shares they bought during the day and the price they will receive for selling their shares on that day.
The NAV of an ETF represents the value of all the securities held by the ETF – such as shares or bonds and cash minus any liabilities such as Total Expense Ratio (TER), and divided by the number of shares outstanding. NAV is most often expressed as the value per share.

On the other hand, ETFs are bought and sold during the day while the markets are open. The pricing of the ETF shares fluctuates continuously during the normal exchange trading hours. Therefore, ETF investors know the exact price they bought at right away and at what price they sold their shares on the market.

If we take a closer look, analyzing the growth of the ETF market we can clearly see that, it took 8 years for the U.S. ETF industry to reach $1 trillion in assets, but going from $3 trillion to $4 trillion took only 2 years. The ETF market began to really take off in the post-financial crisis economy after 2008. The explosive growth of ETFs has been attributed to the fact that after the 08’ economic collapse banks began shedding securities from their balance sheets, while at the same time battered retail investors were eager to find cheap ways to build diversified portfolios going forward.

The presence of tens or hundreds of companies within a certain ETF is something that brings the false sense of “proper” diversification to investors, even though that “diversification” as a term doesn’t stand for “buying as many things as possible in order to spread your capital around”, but instead focuses on buying the best in-class companies across different markets, industries and sectors, preferably at a discount, in order to improve your overall risk-reward and profitability ratios. When you look at a certain ETF, let’s take the Consumer Discretionary SPDR (XLY) for example, it is impossible to come to the conclusion that all 64 stocks that are part of the XLY, are either equally attractive or equally unattractive. If you look closer at every individual constituent of this ETF you will find substantial differences between these companies, when it comes to – profitability, adequate use of capital, R&D, financing, size of operations, market positioning, management capabilities, growth potential etc. Thus, while it is true that buying or selling an ETF gives you a seemingly easy and low-cost access to a specific sector of the market and it does provide you with a certain level of diversification, it is by far not the best investment vehicle out there as in many instances you end up buying problematic stocks alongside the winners.

However, we can’t deny the fact that the ETF market has grown at a tremendous rate in the last decade and that it currently plays a key role for identifying the next move for the equity markets worldwide. Large institutional investors use ETFs for quick and easy exposure to a certain sector for their clients and end up pouring large amounts of capital within the ETF market.

Please check the graph below in order to understand why you need to start paying closer attention to some of the larger ETFs out there.

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