How Exchange-traded Funds Work

• By Rachel Snowden

Exchange-traded funds have recently become an increasingly popular financial instrument used by both private investors and institutional investors. Let's look at what an exchange-traded fund is and how it works.

ETFs are investment funds that boost the performance of a stock market index, industry, or assets, providing investors with access to securities, stocks, alternative assets, commodities, and so on. ETFs are purchased and sold in the same way that stocks are, but they do not sell equities directly since they buy stocks in a portfolio, i.e., they sell a part of an investment portfolio that includes a variety of financial products and assets.

ETF stocks are called creating units, and these stocks are released in big blocks. There are various types of ETFs, for example:

• index ETFs - these exchange-traded funds are trying to track an index underlying, and they are an affordable and effective way to investment in a diverse portfolio;
• actively managed ETFs - such exchange-traded funds are operated by a team or portfolio manager, who adapts this fund to market changes and takes responsibility for the allocation of the portfolio;
• target-risk exchange-traded funds - such funds are also diversified portfolios, a special feature of which is that a management team or fund manager progressively redistributes the fund's assets in order to make the portfolio lower-risk;
• bond ETFs - these funds are investing in bonds, and depending on the type of bonds, they are classified as medium-term bond ETFs, corporate bond ETFs, long-term bond ETFs, high-yield bond ETFs, etc;
• commodity ETFs - these types of funds follow the prices of commodities, such as gold, oil, etc.

Additionally, there are real estate ETFs, global stock ETFs, diversified emerging markets ETFs, mid-cap ETFs and many others, all depending on the portfolio structure of the fund.

The main advantages of ETFs are:

• easily traded;
• low costs;
• transparency;
• diversification;
• access to a wide range of markets.

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So, exchange-traded funds offer the widest range of investment opportunities to investors, and that is why they became so popular. In 2020, the global value of assets under management of exchange-traded funds totaled $7.74 trillion, while the number of exchange-traded funds globally was 7,602, an increase of 2,650% since 2003. The largest share is in the U.S. with $5.45 trillion in net ETF assets and 2,204 ETFs. The European share of global assets in ETFs is 17% - $1.19 trillion, and the number of ETFs is 1,820. Asia-Pacific exchange-traded fund assets under management totaled $690 billion (Morningstar.com; Statista.com).