What is an ETF?

Trades like a stock – Acts like a mutual fund

In short:

An exchange traded fund (ETF) is an investment fund composed of underlying securities like stocks. The goal is to track an index, sector, or other basket of assets and mirror their performance. ETFs get their name from the way their shares trade on exchanges and can be bought or sold just like regular stock – that is, throughout the day and often with low or no commission. Those aspects of ETFs are a major perk that differentiates them from traditional mutual funds whose shares trade only once at the end of the day.

While many ETFs are structured to track stocks, they can also be structured to track many different types of investments, such as commodities, bonds, or other investment strategies.

Well known examples of ETFs include SPDR S&P 500 ETF Trust (SPY) designed to mirror the performance of the S&P 500 and the Invesco QQQ Trust (QQQ) designed to mirror the Nasdaq 100. Both funds have been in operation for over 20+ years and have more than $100B market cap.

Key Points

• Exchange traded funds (ETFs) are a basket of securities whose shares trade on exchanges just like stocks.
• Open to investors with a small amount of capital
• ETFs share’s trade continuously throughout the day.
• ETFs share many similarities with mutual funds but often have lower expenses making them cheaper to own.
• ETFs can be passively managed (track an index) or actively managed (specific investment strategy).

Why ETFs

In-depth:

Exchange-traded funds (ETFs) were introduced in the 1990s and have steadily gained popularity as an investment option in recent years. This rise in popularity is due to a few reasons. First of all, ETF shares are traded on exchanges like the NYSE or Nasdaq just like typical stock shares. This means they can be bought or sold at any time throughout the trading day. So, an investor can decide they like the price an ETF is trading for at 9:45 a.m. purchase the shares like they would a stock, then by 3:30 p.m. decide they no longer what the shares and sell them. In this scenario, the investor has a tremendous amount of flexibility of deciding when to get in and out of an ETF.

The second, ETFs often offer easy access to passive diversification for investors. Instead of looking to build a portfolio of individual stocks that add up to provide diversification to the investor, they can simply buy the diversification already done. There are really two advantages to “buying diversification already done”.

•  First are the reduced monitoring and rebalancing the investor has. Instead of spending time monitoring an array of stocks to make sure one doesn’t hold too much influence on the portfolio, the investor can effectively outsource this to the ETF money manager. 

• The second advantage of buying a pre-diversified portfolio through an ETF is that it benefits investors with a small amount to invest. Buying multiple stocks including expense shares to achieve diversification might not be feasible for someone with a smaller amount of money to invest. With an ETF, they can buy shares and have indirect ownership of those shares they otherwise couldn’t purchase outright.

Exchange-traded funds often cost less to own in terms of management fees. The structure of ETFs allows their shares to trade directly on exchanges and also reduces the administration workload – this results in lower cost to operate the fund. The fund operator doesn’t have as many expenses as they charge a lower management fee to the shareholders. This means the investors who own shares in the fund get to keep more of their profits at the end of the year. Additionally, ETFs often have fewer capital gains tax liabilities than traditional mutual funds, which benefits the shareholders.

Types of ETFs

Since ETFs are a combination of underlying securities that are composed based on the fund objective, there are plenty of different types of ETFs available to investors based on their investing goals and risk tolerance. Types of ETFs available to investors include:

• Index ETFs: The goal of these is to track either the overall market such as the S&P 500 or some subset of the market like a small cap (ex. iShares Russell 2000 ETF “IWM”).

• Sector ETFs: Their objective is to track some sector of the economy like energy stocks, financial stocks, utility stocks (ex. Energy Select Sector SPDR “XLE”). 

• Commodity ETFs: These give access to track the performance of certain commodities (raw materials) such as corn, oil, metal etc. that go into finished products (ex. United States Oil Fund “USO”). 

• Currency ETFs: This type of ETF allows investors to track the changes in values of currencies or basket of currencies and access markets they otherwise couldn’t access to either hedge or speculate on currency values (ex. Invesco CurrencyShares Euro Trust “FXE” ).

• Bond ETFs: These allow investors to access bonds without minimum holding period requirements. An investor gets paid a regular dividend on a bond but forfeits security of return of principal investment. 

• Inverse ETFs: These short-sell stocks with the aim to profit from a decline in those shares prices. 

This is by no means a comprehensive list of all the different types of ETFs that are available, rather a sample of the most common and most popular.

Advanced uses of ETFs

While it may be easy to write ETFs off as a quick way to a diversified and boring portfolio that will slowly move along and only track an index such as the S&P 500, making such an assumption would be unsound. Even for advanced enterprising investors looking to outperform the market, ETFs can and do play a critical role in their portfolio construction.

Example

Take an enterprising investor who’s looking to outperform the market and wants to add some risky young electric vehicle companies to their portfolio. The investor already has a portfolio consisting of 80% long-term single stock picks that have consistently beaten the market in the past. In addition to this, the other 20% of the investor’s portfolio is currently cash. The investor has proven a good investment analyst in the past but with young electric vehicle companies, there’s just not enough information to be sure of any single company. So the investor, wanting to participate in any upside and willing to invest 12% of their cash, decides to look at an ETF that focuses in the electric vehicle space. This way, the investor doesn’t have to make one or two risky speculations and instead is speculating on a group of companies. 

The investor was able to reduce the risk of an aggressive investment they wanted to make while not giving up all the potential upside by looking to an ETF that specializes in a certain area. This is an example of making a diversified investment in a certain industry, but it should not be confused with a balanced and diversified portfolio. The only diversification benefit the investor receives from the ETF is on the electric vehicle space.

Are there ETFs that outperform the market?

ETFs that outperform the market regularly do exist. A prominent example is the Invesco QQQ Trust with a trailing 10-year average annual return of 20%. 

The important thing when looking for ETFs to outperform the market is to know what you are buying. Questions to ask could include: is this an actively or passively managed fund? What are their top holdings? Are their top holdings very concentrated, and if so would you a potential investor feel comfortable owning those companies or assets outright? 

Additionally, just because a fund is an ETF does not make it easy to trade its shares. If the ETF is small (with low net assets) or its average trading volume is low, it may be hard to get in and out of the fund as quickly as you would like.

Key Points

• Just because it’s an ETF does not mean its broadly diversified or “less risky”
• ETFs can be used to outperform the market
• Not all ETFs are highly liquid

How exchange traded funds work – mechanics

Most of the benefits people like about ETFs such as intraday trading and tax efficiencies comes from a process called creation and redemption. This is the process of creating new ETF shares or redeeming (reducing) ETF shares with the help of specialized investors called authorized participants (APs) and is what allows shares of ETFs to trade like regular stock.

Why ETFs trade like regular stocks

The first thing to understand as to why ETFs trade like regular stocks is the difference in markets, that is, primary vs secondary. With traditional open-end (more shares can be issued) mutual funds, an investor who wants to buy shares in the mutual fund will need to buy the shares directly from the mutual fund -this is called the primary market.

With an ETF, when an investor wants to buy shares they can do so through an exchange such as the NYSE or Nasdaq – this is called the secondary market. When an investor buys shares on an exchange they are buying the shares from another investor not directly from the ETF company. This allows the shares to trade hands more quickly and lowers the overhead expenses for the fund.

The major difference between traditional open-end mutual funds and ETFs is effectively this aspect. ETF shares can be traded between investors whereas shares of mutual funds must go through the fund itself. But how do ETF shares get on secondary markets in the first place?

Making new ETF Shares – Creation

When an ETF wants to issue additional shares instead of dealing with many investors directly, they use a specialized investor called an authorized participant (AP). The AP will go out and buy the shares of stock from the index the ETF is tracking and sell/exchange those shares to the ETF in exchange for shares of the ETF. At that point the AP will take the new shares of the ETF and sell them to the secondary market where other investors will have access to buy and sell the new shares.

Trading at a premium – signal to issue more shares

ETF shares are trading on the secondary market for normal investors to buy and sell. What happens if the shares of the ETF start to sell for more than the shares of a particular index are supposedly worth? To put numbers on it, what if ETF value is $50/share when the shares of the underlying index are only worth $48/share? 

This would indicate that the ETF is out of balance. There is more demand for ETF shares than the supply of shares, which pushes the value of the ETF shares out of line with the index.

At this point, an authorized participant has an incentive to restore equilibrium to the ETF and bring the share value of the ETF in line with the share value of the underlying index. To do that, the AP buys shares of the index and exchanges them with the ETF fund in return for shares of the ETF. Once the AP has done this they will sell any additional ETF shares to the secondary market, adding to the supply of ETF shares in response to the demand.

Redemption

When an ETF needs to reduce its number of outstanding shares, it uses the process of redemption with the assistance of an AP. The AP will buy shares of the ETF on the secondary market until it has enough shares to sell to the ETF in exchange for shares of the underlying stocks, effectively reducing the number of outstanding shares.

Trading at a discount – signal to reduce share count

We saw what happened of shares of the ETF started to sell for more than the underlying shares were worth when we looked at creation. But what happens if shares of the ETF start to sell for less than the underlying shares are worth. Or another way to say it, what if our ETF shares are trading at $75/share when the shares of the underlying index are worth $77/share?

Once again this would indicate that our ETF is out of balance. There is more supply of shares of the ETF than there is demand for the shares causing the shares to fall out of line with the index. At this point, an authorized participant has an incentive to restore equilibrium to our ETF and bring the share value of the ETF in line with the share value of the underlying index. In order to do that, the AP will go out and buy shares of the ETF which they will exchange with the ETF fund for shares of the underlying index. Once they have the shares of the underlying index they will sell them back to the market. This process will reduce the number of available ETF shares to match the current demand for those shares.

ETFs vs mutual funds

Both ETFs and mutual funds have their place, and both can be good investments for an investor. Many employers offer a selection of mutual funds in their 401k plans offering easy access for many people already. That said, generally, ETFs offer more advantages than mutual funds for a few reasons some of which were mentioned above.

First, lower average cost both in management fees and taxes. ETFs are able to raise their cost basis much more efficiently than mutual funds often giving them and their owners a much smaller capital gains tax bill. Additionally, given their structure, they are often cheaper to manage for the fund operator who passes those savings to ETF shareholders.

The second advantage is tradability during the day and no minimum investment. For small investors no initial investment minimum means that with only a few hundred dollars they can become an owner of the ETF. Trading during the day also allows investors faster transactions instead of having one opportunity a day to get in or out (how mutual funds trade).

ETFs vs stocks

Just buy ETFs and forget about individual stocks? Maybe not the best plan and certainly depends on the investor. Someone who is incredibly passive and wants to put no effort into investing would likely be better off focusing only on ETFs, mutual funds, or other managed investments.

Owning individual stocks can be a part of any sound investment strategy for an enterprising investor. The difference would be the amount of effort, research, and strategy employed. Countless examples could be given of adding individual stocks on a non-speculative basis would increase the overall performance of the investor’s portfolio. In all cases, investment decisions should be made by the investor after careful consideration and counsel from a trusted qualified professional.

ETFs Mentioned Above