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Investment & Finance

ETFs: What They Are and How They Work

By
Richard Sun
Updated
December 4, 2023
5 minute read
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Exchange-traded funds, or ETFs, are a type of investment that can offer exposure to a wide variety of asset classes in a single fund. ETFs are traded on stock exchanges and can be purchased and sold throughout the day at market prices. ETFs typically have lower fees than traditional mutual funds and can be a helpful addition to any investment portfolio. Let's take a closer look at how ETFs work.


What is an ETF?

An exchange-traded fund, or ETF, is a type of security that tracks an underlying index, commodity, or basket of assets. ETFs are traded on stock exchanges and can be bought and sold throughout the day at market prices. ETFs typically have lower fees than traditional mutual funds and can offer exposure to a wide variety of asset classes in a single fund.


How Do ETFs Work?

ETFs are managed by investment firms that work to track the underlying index, commodity, or basket of assets. The firms invest in the underlying assets in order to match the performance of the target index as closely as possible. When you invest in an ETF, you are essentially investing in all of the underlying assets within the fund. For example, if you invest in an S&P 500 ETF, you are investing in all 500 stocks that make up the S&P 500 Index.


The price of an ETF is determined by the collective value of its underlying assets. When you buy or sell an ETF, you are transacting at the current market price. Because they are traded on stock exchanges, the prices of ETFs can fluctuate throughout the day just like stocks.


Benefits of Investing in ETFs

There are many benefits to investing in exchange-traded funds including:


Low Fees: One major benefit of ETFs is that they typically have lower fees than traditional mutual funds. This is because ETFs do not require active management and there is no load fee associated with the purchase or sale of the fund.


Diversification: Another benefit of ETFs is that they offer exposure to a wide variety of asset classes in a single fund. This can help reduce risk by diversifying your investment portfolio across multiple asset classes. For example, instead of investing only in stocks, you could invest in an All Asset Class ETF which includes stocks, bonds, commodities, and real estate all within one fund.


Tax Efficiency: Another advantage of ETFs is that they tend to be more tax efficient than traditional mutual funds because they generate fewer capital gains distributions.


Flexibility: Lastly, ETFs offer more flexibility than traditional mutual funds because they can be bought and sold throughout the day at market prices. This gives investors more control over their investments and allows them to take advantage of market fluctuations.

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How alphaAI Can Help

At alphaAI, we love ETFs for all the reasons described above. We hold ETFs in most of our strategies because they allow us to better control things like volatility, risk, and exposure. Below is an example portfolio breakdown chart of an example strategy, which shows how we use ETFs to diversify our exposure to different sectors and industries. Learn more about how we use ETFs to help clients meet their financial objectives here!


Example Portfolio Breakdown by Sector

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