An Exchange-traded Fund (ETF) is an index-tracking investment vehicle listed on a major exchange. Indices are composed of a basket of securities, usually belonging to a specific asset class, such as stocks or bonds, in a particular segment of the market, such as technology, energy, or real estate.
Composed of numerous securities, an ETF offers diverse exposure to the market, also known as diversification, helping an investor mitigate risk. How? Historical data indicate that long-term, diversified portfolios typically earn higher returns because they average out the fluctuations of a single stock. Investing in a portfolio of ETFs, is the simplest, cheapest way to achieve diversification.
Shareholders of ETFs earn returns through dividends and growth in the value of the underlying securities, the way they would if they were invested in individuals stocks. ETFs offer high diversification for very low fees, with highly liquid instruments. Because of these features, ETFs are very popular: in 2016, 14 out of the 15 most active securities were ETF, and only one was a stock (Apple).
ETFs also offer low fees. ETFs follow an algorithm by mirroring the composition of a given index; for this reason, the costs incurred are significantly lower than their actively-managed unit trust counterparts that require fund managers to make investment decisions continually.
An example of an ETF and how it works
There are several ETFs that track the S&P500 index, which is a stock market index that tracks 500 large companies traded on the New York Stock Exchange (NYSE) or NASDAQ. The largest of these ETFs that track the S&P500 is SPDR S&P500, which trades under the ticker SPY on the NYSE. SPY has USD 240+ billion under management and is the most heavily traded security in any exchange globally. SPY offers exposure to US Large-Cap equities for 0.09% per annum; for comparison, according to Cerulli, equity funds in Singapore charge a median annual management fee of 1.5%, or 1.41% higher than SPY.