How do ETFs work in Dubai?

Exchange-Traded Funds (ETFs) are funds traded on stock exchanges, much like stocks and bonds, and own assets such as stocks, commodities or bonds. Unlike traditional mutual funds, an ETF does not sell shares directly to investors and trades like a common stock on a stock exchange.

Most ETFs track an index; others may follow active strategies such as quantitative investing. Some offer exposure to multiple asset classes, while others offer exposure to a specific market segment, country or geographic region.

Typically an ETF invests in the securities that make up the underlying index but may use futures and derivatives to provide additional leverage to enhance performance.

While investors generally purchase ETF shares through a brokerage account, institutional investors are responsible for their creation by investing in the corresponding portfolio of assets which are then exchanged with the ETF issuer in return for baskets of securities representing an equal value of stocks or bonds.

The unique aspect about how they work is that they trade intraday like stocks but retain all characteristics of traditional commodities. It gives rise to substantial benefits for both active traders and long term investors alike.

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What are the benefits of trading with ETFs?

Transparency and Flexibility

ETFs offer greater transparency and liquidity since they track an index or benchmark – not a fund manager’s portfolio. You can easily see what securities each ETF holds through its prospectus – something that you don’t get with closed-end funds (although these days, regulators insist on more disclosure ). Closed-end funds may trade at premiums (above net asset value) or discounts (below NAV).

Investment Efficiency

ETFs can provide many benefits over other investment vehicles. For example, unlike mutual funds or hedge funds (or traditional commodities), ETFs trade like stocks on an exchange. It provides more flexibility for investors and greater liquidity for market makers.

Lower Costs

ETFs typically have lower costs than actively managed mutual funds because of the smaller staff to operate. Since most ETFs are index funds, their expenses are much lower than actively managed equity mutual funds, which attempt to outperform their benchmarks with actively made security selection decisions. Lower expenses mean that more of your investment returns go directly into your pocket instead of covering operational costs. Furthermore, ETFs are even more tax-efficient than mutual funds by trading intraday.

Simplicity

ETFs are simple to use, transparent, highly liquid and low cost. An ETF provides an easy way to track the performance of a given index or sector without the need for expensive due diligence. There’s also no asset allocation required on your part if you don’t want it.

Diversification Across Asset Classes

Most investors have exposure to stocks through their retirement plan at work or direct ownership in an IRA account. But these days, ETFs offer exposure to other asset classes that may be appealing depending on one’s investment goals or risk profile. These include fixed income, currencies, international equities, commodities, futures contracts and much more.

What are the risks of trading ETFs?

Market Risk

ETFs expose investors to market risk, i.e. the risk that the value of the ETF will decline due to a general decline in stock or bond prices. Some ETFs attempt to minimize this exposure by writing covered call options on their underlying stocks (selling call options at a strike price above current market value). Other ETFs employ hedging strategies such as futures contracts and dynamic asset allocation models, which rely on varying leverage degrees.

Tracking Error

Actively managed funds have a history of underperforming benchmarks over time because active managers have relatively broad discretion about what securities to hold in their portfolios. In addition, index funds may not perfectly track their indexes due to expenses associated with portfolio management, trading, tracking error (difference between the expected return of the index and the actual return of the index fund), or other factors.

Early Redemption Fees/Sales Charge

ETFs may come with early redemption fees assessed when you sell your shares if you redeem them before a certain period passes. ETFs charge front-end sales charges, which can increase broker commissions paid by investors. It generally isn’t an issue for institutional investors who buy large blocks of shares, but it can be pricey for individual investors who buy small numbers of shares over time.