What Is an ETF? Definition, Types and How ETFs Work

What Is an ETF? Definition

ETF definition: An ETF is an investment fund that you buy on the stock exchange. An ETF represents a portfolio of securities or other assets that you can invest in. Buying one ETF share is the equivalent of buying a slice of all the holdings in the ETF. An ETF is therefore similar to a mutual fund, but with lower fees.

ETFs are also known as “exchange-traded funds” or “trackers”. In finance, an ETF is an index fund or basket of securities that aims to replicate the performance of a stock market index. For example, with an ETF that tracks the CAC 40, you can invest in most of the companies in the CAC 40.

So you need to choose carefully which companies will make up your ETF portfolio. To help you, choosing a good broker is essential. A quality broker will help you make successful investments.

On related topics, our articles “CFD vs ETF“, “Bitcoin ETF” and “ETF” are a good complement to this read.

ETF Synonyms

Several terms are used to refer to ETFs on the stock market. Here is a list of words with the same meaning as ETF:

Tracker;
Exchange-traded fund;
FNB (French abbreviation);
Exchange Traded Fund;
ETFs;
Tracker fund;
Index tracker.

ETF Etymology

ETF is an acronym for “Exchange Traded Fund”, known in French as “Fonds Négocié en Bourse”.

Key ETF Terms and Vocabulary

ETF share – definition: A share is a title of ownership, or a portion of a company’s capital. An investor buys a company’s shares in order to receive a portion of its profits in the form of dividends. A shareholder may also enjoy certain rights, such as taking part in the governance of the company. Note that an ETF is similar to a share because it is a security that can be traded on the stock exchange. In fact, the value of an ETF moves with market trends.
Stock market index – definition: A stock market index is a set of shares or bonds used to analyze the stock market or the economy. These shares and bonds are grouped together in a portfolio. To be included, they must meet several criteria. For example, they may need to be companies from a specific sector, or the largest companies in a country or continent, etc.
Investment fund – definition: An investment fund, or mutual fund, is a way of pooling money to help finance companies. An ETF is, in a way, an investment fund spread across several financial assets such as shares, bonds, forex, etc.
ETF investment portfolio – definition: An ETF investment portfolio is a group of securities and other financial assets designed to generate income. This portfolio brings together traditional securities, but it also includes derivatives such as futures or options.
Passive investing – definition: Passive investing is a strategy that involves investing capital through a portfolio built by the trader that will not be changed. In other words, investing for the long term while keeping fees low and buying and selling as little as possible.

Other Definition

ETF medical definition: ETF is also an acronym in medical terminology. In medicine, ETF (in French) stands for transfontanellar ultrasound. It is a technique for examining the intracranial area through an infant’s fontanelle. This imaging tool allows a morphological and vascular examination of that area.

The Different ETF Positions and Their Definitions

Opening a long ETF position – definition: Opening a buy position on an ETF means opening a position to own a portion of an ETF and profit from it. Investing in ETFs is a form of portfolio investment.
Opening a short ETF position – definition: Opening a sell position on an ETF means aiming to profit when ETF prices fall. You can open a sell trade using CFDs on ETFs.
Modifying an ETF position – definition: Modifying an ETF position means, as the name suggests, changing the parameters of an open ETF position, such as stop loss or take profit levels. These levels are used to close a position when a given value/price is reached.
Closing an ETF order – definition: Closing an ETF order means closing an open ETF position. In other words, it involves setting a profit or loss level at which the position is closed. This can be done automatically using a take profit or a stop loss.

How Do ETFs Work?

As we saw in the definition, an ETF is an investment fund. ETFs are issued by asset management companies, and their value depends on the performance of the stock market index they are linked to.

To better understand how ETFs work, you first need to understand the concept of a stock market index.

As a reminder, a stock market index is a set of shares and bonds that serves as an indicator to measure a market’s performance. It is made up of several financial instruments, each with its own market value/price. So if the value of the instruments rises, the value of the index rises too, and vice versa when they fall.
ETFs work in exactly the same way. When the prices of the assets in the ETF rise, the value of the ETF also rises, or tracks that trend. And when they fall, the opposite happens. However, you need to take into account how the weightings of the assets in the ETF are distributed.
When an asset with a high weighting changes price, it has a big impact on the rest of the ETF. Conversely, for an asset with a lower weighting, the impact will be smaller.
In practice, if you buy an ETF on the CAC 40, i.e. the 40 leading French stocks, buying a single product gives you exposure to the whole CAC 40 basket. So if the CAC 40 index rises, your ETF or tracker will move in the same direction.

What Are Distributing and Accumulating ETFs? Definition

Distributing ETF – definition: A distributing ETF is a type of ETF that pays dividends to its holders.

Accumulating ETF – definition: An accumulating ETF is a type of ETF that does not pay dividends to its holders. Instead, the income received is reinvested and has a positive effect on the ETF’s price for investors.

What Is the TER? Definition

For ETFs, TER stands for Total Expense Ratio. The TER measures all the costs of managing collective investment schemes.

What Is UCITS? Definition

UCITS stands for Undertakings for Collective Investment in Transferable Securities. It is a European directive intended to harmonize European markets. This directive standardizes information about funds across several European countries.

What Is a Structured ETF? Definition

A structured ETF is a type of ETF that can offer different risk profiles. A structured ETF can provide full capital protection, or be high risk through the use of leverage. With structured ETFs, traders can therefore win big or lose big.

The Two Types of ETF Replication

ETFs aim to replicate the movements of the index they are linked to as closely as possible. Differences between an ETF and its index are measured by “tracking error”. When tracking error is low, the ETF better meets its management objective, namely to mirror a market’s movements without exceeding them.

ETFs can track indices in two ways: physical replication and synthetic replication.

Physical ETF or Physical Tracker – Definition

A physical ETF replicates the performance of the index it is linked to. To do so, it buys the same securities that make up the index, in the same proportions. So if you invest in a physical ETF, it is as if you were buying all the securities that make up that index.

Physical replication can be full or partial. It is full when ETFs replicate their index’s performance by holding all of its constituents in identical proportions.

Physical replication is partial when the index replicated by the ETF is hard to track, i.e. when shares are difficult to buy or sell because of a lack of supply or demand on the stock market. Partial replication is essential in this situation because full replication would be too expensive for the fund, given the trading costs involved. That is why some ETFs opt for partial physical replication.

Synthetic ETF or Synthetic Tracker – Definition

A synthetic ETF is similar to a partially replicated physical ETF, except that it tracks the index as closely as possible. It is also known as an indirect ETF. This type of ETF uses swaps to track its benchmark index. Swaps are contracts between two parties based on protection, which allow the trader to transfer the risk they face to another party.

*68% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.

What Are the Different Types of ETFs?

An ETF type is a group of ETFs with identical characteristics. ETFs are financial instruments that can have different distinguishing features. Every trader needs to know them in order to become a good trader. Here are the different types of ETFs you should know:

Index ETFs – Definition

An index ETF mirrors the characteristics of a stock market index such as the CAC 40 or the S&P 500. An exchange-traded fund buys or sells company shares according to their weighting in the index. The higher a company’s weighting in the index, the more of its shares the ETF portfolio will hold.

Commodity ETFs – Definition

Commodity ETFs are exchange-traded funds that track the value of a commodity. These ETFs can also cover agricultural assets. For example, there are oil, gold and vanilla ETFs, etc.

Selected assets can make up commodity ETFs. These ETFs can also include holdings in company shares whose price depends mainly on the value of commodities.

Inverse ETFs – Definition

Inverse ETFs are trading instruments that move in the opposite direction to their underlying ETF. So when the underlying rises, the inverse ETF falls, and vice versa. For example, the Lyxor CAC 40 Daily (-2) Inverse ETF is the inverse of the CAC 40.

Actively Managed ETFs – Definition

An actively managed ETF is a fund that frequently changes its composition. A passively managed ETF, on the other hand, rarely changes. Passive management is typical of ETFs linked to specific stock market indices. These ETFs deliver returns identical to those of the index.

Sector ETFs – Definition

Sector ETFs are funds made up of companies from a specific sector of the economy, such as pharmaceuticals, banking or food. A trader who buys units in this kind of fund is betting on the growth of the whole sector.

Foreign Market ETFs – Definition

A foreign market ETF is made up of shares in companies outside the trader’s home country. These ETFs take into account the specific features of the economies where these companies are based. They also take into account the exchange rate, which may or may not work in the investor’s favor.

Bond ETFs – Definition

Bond ETFs are funds made up of bonds. They work like a portfolio of many bonds, which may be corporate bonds, municipal bonds or government bonds such as the German 10-year Bund.

ETF Definition: Conclusion

To conclude, remember that an ETF is an investment fund that can be made up of shares or bonds from several companies. Investing in ETFs is low-cost, and they are managed to replicate a stock market index, faithfully tracking its performance. Also called trackers, ETFs (exchange-traded funds) are a very good way to invest in the stock market. With an ETF, a trader can invest in several companies at once, as well as in bonds.

Read also: Crypto Stocks