How Does ETF Trading Work?
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What is an ETF?
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An ETF, or exchange traded fund, is a type of investment that is traded on a stock exchange that holds other assets, like stock in other companies, bonds and commodities, much like a mutual fund. ETFs are usually designed to hold assets in certain sectors or indexes in the stock market, so their value generally follows the price of the underlying stock prices. ETFs are created by financial institutions with broad holdings of assets, which set aside a block of assets that reflects a certain market, and investors buy shares of those blocks of assets.
Benefits of an ETF
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ETFs have several benefits that make them attractive to investors, the foremost being that they are traded daily like any stock, so they can be bought and sold at any time. ETFs offer diversification due to the many different underlying assets, and their holdings are transparent, so the investor can find out exactly what assets an ETF holds. Another advantage is that ETFs are not actively managed, so they have low costs, and therefore few fees are passed on to the investors. Since they are traded daily, trading strategies such as short selling, stop loss and buying orders if they pass a certain price can be employed.
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Differences Between ETFs and Mutual Funds
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EFTs and mutual funds are similar in that they both hold a bundle of underlying assets that determines the value of the fund. A major distinction is that mutual funds are not traded actively during the day--they can only be bought or sold once a day, at the end of the trading session. ETFs usually have lower trading costs than mutual funds, but a broker must still be used to trade shares at a nominal commission rate. Another advantage of ETFs is that they are more tax efficient than mutual funds; whenever a mutual fund reorganizes its investments, the holders must pay capital gains tax, but in an ETF capital gains are usually only paid when the investment is sold.
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