An Exchange Traded Fund (ETF) is a very popular method used by both traders and investors. It can be considered as very similar to a normal equity or security, i.e. people trade ETFs on exchanges (Dow Jones, FTSE etc.) just like common stocks. ETFs tend to be set up in order for them to track the performance of a certain index, or certain baskets of assets such as commodities, bonds, etc., or even to perform inversely to an asset which is in a strong bear market. They can also be set up to provide a trader with a low element of leverage in order to enhance profits if the ETF does indeed perform in their favour. Unlike mutual fund shares, there is no need to calculate NAV at the end of each day when trading ETFs, because they are traded openly – just like stocks.
When an exchange traded fund is created and a certain basket of assets is specified. Ownership of each asset class is then divided into shares, thus when market participants purchase ETFs they will be investing into the predetermined asset classes and will be naturally diversifying their portfolio. However, it needs to be understood that shareholders who purchase ETFs do not become owners of the underlying assets, they are indirect owners only.
Traders often use ETFs to find arbitrage opportunities within the financial markets. As they are publicly traded, the price of an ETF might differ slightly at a given time when compared to the actual price of the underlying asset(s). The price of the ETF would be the average price of these underlying assets, calculated using constituent parts of that fund. One way to exploit the arbitrage opportunity might be to hold two open positions, e.g. buy the ETF and sell the underlying portfolio.
The aforementioned inverse or leveraged ETFs which are also available could be used to help specific trading styles. Like anything related to trading, the important thing is to understand how to use different instruments for one’s purposes, and then how to incorporate them into ones’ strategy execution.