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An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have lower fees than mutual fund shares, making them an attractive alternative for individual investors. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a mutual fund does.
Advantages of ETFs
1. Trading Flexibility
Traditional open-ended mutual fund shares are traded only once per day after the markets close. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid or sold that day
ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares is continuous during normal exchange hours
2. Portfolio Diversification and Risk Management
Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment.
3. Lower Costs
ETF operation costs are low as client service–related expenses are being passed on to the brokerage firms that hold the exchange-traded securities in customer accounts. Fund administrative costs can go down for ETFs as the manager does not have answer questions from thousands of individual investors. ETFs also have lower expenses in the area of monthly statements, notifications, and transfers.
- Limited to Larger Companies
In some countries, investors might be limited to large-cap stocks due to a narrow group of stocks in the market index. This could leave potential growth opportunities out of the reach of ETF investors.
- Bid-Ask Spread Can Be Large
Low volume ETFs lead to huge bid and ask spread for the ETFs share
Negative impact of ETF to the capital market
The emergence of robot advisor and ETFs are an important development in financial markets, which have brought many well-documented benefits to investors. However, the emergence of this trend has led to several unintended long run consequences for pricing efficiency:
- Higher ownership of individual stocks by ETFs widens the bid-ask spreads in the share, making them more expensive to trade and less attractive
- When fewer trades occur, liquidity in single stocks deteriorate, raising transaction costs and further discourages professional traders
- The reduced interest in individual equities results in lesser analyst coverage
- Fewer signals about corporate performances seeped into prices over time because of passive investing. Good management are not being rewarded by the market when their company is not in the ETF basket while bad management are not being punished by the plunge in share price. This has led to inefficiency in the market.
- Industry bets mattered more than single stock bets as passive vehicles chopped up the market into sectors. For example when a steel theme is in play, both good and bad company prices rise when the market consistently pouring money into the steel ETF instead of picking a good steel counter. This led to a huge market mispricing which eventually harming all investors.
ETFs are a great innovation, but an over-population of any innovation could cause unintended consequences if left unmonitored.
Source: The Edge Singapore, Investopedia, The Star, Bursa Malaysia, Fidelity