First let us see what an ETF is first. An exchange-traded Fund is a kind of mutual fund and in particular, exchange traded product, i.e. they are traded on major stock exchanges like the New York Stock Exchange (NYSE) or the NASDAQ. Funds and ETFs are not the same thing but investors often use the two terms interchangeably. However an ETF is typically managed by a fund manager while a fund is managed by an investment management firm that specializes in mutual funds and their various offerings.

The main advantage of ETFs is that they enable investors to achieve maximum diversification of their portfolios and thus reduce the risk of any one of the investments falling to a negative percentage. By buying ETFs instead of individual securities, investors can eliminate risks associated with holding different kinds of stocks and bonds. For example, if you own U.S. stocks, but also invest in emerging markets like India, Brazil and China, then holding all those stocks would be a double-edged sword, since even if those markets grow and fall in value, you may end up losing money because you bought stocks with high liquidity and now they fall in price. This happens because ETFs do not have the same volatility as stocks and bonds so there is little chance of losing your investment in the event of market changes. On the other hand, when you own ETFs, you are only diversifying your portfolio but not limiting yourself to just U.S. stocks or just equities.

On an important point of comparison between an ETF and a mutual funds, an ETF is an entity itself and does not offer any products or services to the investor. Mutual funds on the other hand offer multiple products and services to the investor, most commonly as index funds or hybrid products. In addition ETFs do not require the investor to hold the securities directly as a security or in an account. Instead the investor is provided with a “carrier” account that allows for the transfer of ETFs between brokerage accounts and custodians. An ETF can be thought of as an I Know Someone product where the broker acts as a facilitator and account holder, providing liquidity to the investor. The difference between an ETF and mutual funds is that an ETF is more passive and less leveraged than mutual funds and indexed bonds.

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