What Is An Exchange-Traded Fund (ETF)?

Posted on Monday, September 10th, 2018 MarketBeat Staff

There is a saying that necessity is the mother of invention. In many cases, new ideas are only created when a need (real or perceived) arises. Such was the case for exchange-traded funds (ETFs).

It was a dark and stormy month for the stock market in October of 1987. Between October 14 and October 19, the major stock market indexes dropped at least 30 percent. Then on Monday, October 19, known as "Black Monday", the Dow dropped 508 points, which represented 22.6% of its total value. The S&P 500 suffered similar losses, losing 20.4% of its total value. At the time, it was the largest single-day loss in Wall Street history.

Of the many reasons that economists and historians cite for the crash, one was illiquidity. Retail investors (people like you and me) had holdings that did not allow them to sell until the end of the trading day, and they took huge losses. In the aftermath of the crash, the Securities & Exchange Commission (SEC) made an invitation to create a market-basket vehicle, similar to a mutual fund, but based on the S&P 500. This would allow investors to invest in the market and to step out of the market when they wanted to. After a few years, this led to the creation of the first exchange-traded fund known as SPY.

This article will define what an ETF is and how it is different from both an index fund and a mutual fund. In doing so, we’ll outline the benefits that these funds offer investors that make them a popular investment option for traders.

What is an exchange-traded fund (ETF)?

An exchange-traded fund is a pooled investment vehicle that has some of the attributes of owning individual stocks and some attributes of owning a mutual fund or an index fund. To some investors, it represents the best of both worlds, and here’s why.

One of the major attractions of owning a mutual fund or index fund is the diversification it provides. Because of the range of options that are available, you get diversity not only between asset classes (stocks, bonds, commodities, etc.) but within niche asset classes (small-cap, mid-cap, emerging markets, technology, oil, etc.). Owning a basket of comparable securities helps investors with a low-risk tolerance because if any individual security in the ETF is underperforming, there will typically be other securities that are moving up.

How are ETF shares created and why are they created?

Exchange-traded funds were created to combine the benefits of a mutual fund with the versatility of trading individual securities. However, individual investors do not have access to the ETF sponsors (the primary market for ETFs). Therefore, ETFs use a specific process for exchanging baskets of securities known as creation and redemption.

 Creation: An authorized participant (AP) works directly with the fund sponsors to exchange the underlying assets that make up an ETF portfolio in exchange for ETF shares, typically in large standardized quantities between 25,000 – 200,000 ETF shares.

Redemption: The AP delivers ETF shares to the fund and receives the basket of assets that make up the ETFs portfolio.

Buying and Selling: Because only the authorized participants can request or redeem creation units, it helps ensure that new shares are priced as close to the Net Asset Value (NAV) of the securities within the fund. Since both the ETF and its underlying assets can be traded throughout the day, traders can take advantage of momentary differences in the NAV that helps keep the ETF price close to its fair value.

How is an ETF different from an index fund?

ETFs are more like index funds than mutual funds, but they still have some distinct differences. As you will see, in some cases index funds have the edge over ETFs:

  • ETFs offer more investment choices– ETFs can be constructed to follow almost any index or asset class. This makes them more versatile than index funds which are more restricted in their available options.

  • ETFs allow different trading strategies– ETFs allow short selling and offer products such as inverse ETFs and Currency ETFs that can be used for market hedging and managing currency risk.

  • ETFs have a different cost structure– On the one hand, because of the way ETFs are created, they allow investors to avoid the costs that are associated with rebalancing. Index funds incur costs by constantly rebalancing throughout the day. On the other hand, index funds themselves can be bought and sold without transaction costs. An investor will have to pay a brokerage commission when trading ETFs.

  • ETFs do not immediately reinvest dividends– This is another area where index funds can be a better option for investors. Index funds immediately reinvest their dividends while ETFs continuously accumulate dividends and distribute them quarterly.

  • ETFs are more tax-efficient – The in-kind creation/redemption feature means that investors are never selling securities that can trigger a tax event. Index funds trigger capital gains every time securities are sold. Another way ETFs avoid capital gains is in the way a fund will transfer securities that have the highest unrealized gains out of the fund as part of their in-kind creation/redemption process.

  • ETFs charge fees for rebalancing – If investors want to rebalance their ETF portfolio they may have to pay multiple commissions, whereas there is typically no charge for rebalancing an index fund. Also, it can be easier to fine-tune an index fund because investors can trade fractions of fund shares.

  • ETFs are not as efficient for dollar-cost averaging– Because investors have to pay a commission when they trade ETFs, index funds may be a better choice for investors who are looking to employ this strategy.

  • ETFs can suffer from price volatility and restricted liquidity– Index fund investors have the assurance that they will get the end-of-day Net Asset Value (NAV). Because ETF shares can be traded like a stock, there may be a wider difference between the market price and the NAV which can result in a higher trading cost.

How is an ETF different from a mutual fund?

Exchange-traded funds are different from mutual funds in several key ways:

  • Investors can trade in and out of an ETF just like if they were trading an individual security. If you’ve ever sold shares in a mutual fund, you have learned that the trades are conducted at the end of a trading day. The selling price is based on the Net Asset Value (NAV) of the shares at the time the market closes. Shares in an ETF can be traded throughout the day on any of the organized stock exchanges (that’s why they’re called “exchange-traded” funds). The trades are executed at the market price at that moment. This makes ETFs a popular option for active traders.

  • Exchange-traded funds give traders more options. Unlike mutual funds, investors in ETFs have the ability to sell short or execute margin trading.

  • A mutual fund is actively managed. This simply means that a portfolio manager is responsible for selecting which securities are part of the fund, and how those securities are weighted. Most (but not all) ETFs are passively managed, meaning that the composition of the fund is based on a published index that determines which securities to hold and how much weight they will have in the ETF. In this way, an ETF is similar to an index fund.

  • ETFs generally have lower operating costs than mutual funds. If you have an active portfolio manager, you are paying for their expertise in deciding which securities make up the fund. In a passively managed fund, those decisions are already made, which reduces the funds’ expenses.

  • ETFs provide more transparency for investors. Every ETF is required to disclose their holdings every day, so if you are buying shares in an ETF that is pegged to a particular benchmark index you will know exactly what securities comprise that index.

  • ETFs offer tax advantages. The ability to trade ETFs like stocks makes them more tax efficient than mutual funds because capital gains are only assessed at the time shares are bought and sold. With a mutual fund, capital gains are assessed whenever the fund buys and sells the securities within the fund.

  • ETFs have no investment minimums or sales loads. Investors can buy as much or as little of an ETF as they want. If an investor wants to buy just a single share, they could. Mutual funds require a minimum investment that can be several thousands of dollars. Some mutual funds continue the practice of charging a sales load (simply put, a commission) for every transaction.

What are some of the most popular ETFs and what indexes do they track?

This is a list of some of the most popular ETFs for different sectors.

Broad Market Exchange-Traded Funds (Trading Symbol)

What it tracks

Spider (SPY)

S&P 500 Index

iShares Russell 2000 Index (IWM )

Russell 2000 Index

PowerShares (QQQ)

Nasdaq 100

SPDR Dow Jones Industrial Average ETF (DIA)

Dow Jones Industrial Average

Sector Exchange-Traded Funds (Trading Symbol)

What it tracks

VanEck Vectors Oil Services ETF (OIH)

Oil Companies

Energy Select Sector SPDR (XLE)

Energy Companies

iShares US Real Estate (IYR)

Real Estate Investment Trusts (REITs)

VanEck Vectors Biotech ETF (BBH)

Biotech

Commodity Exchange-Traded Funds

What it tracks

United States Oil Fund (USO)

Crude Oil

SPDR Gold Shares (GLD)

Gold

iShares Silver Trust (SLV)

Silver

United States Natural Gas Fund (UNG)

Natural Gas


Specialized ETFs that investors may want to avoid

Inverse ETFs – as their name implies, these ETFs are designed to allow investors to profit from the decline of a market index. These are often called Short ETFs or Bear ETFs and they can be an attractive option for investors who don’t want the larger risks of short selling.

Alternative Investment ETFs – these ETFs help investors who want to employ more sophisticated investment techniques such as profiting from low market volatility, trading different currencies to earn a higher interest rate, or using covered call writing.

Actively Managed ETFs – These ETFs are known as Intelligent ETFs or Smart ETFs. They employ an active investment strategy. This means that a fund manager may choose to exclude some stocks from the corresponding index or change the way certain stocks are weighted. These funds also have higher expense ratios than traditional ETFs.

Leveraged ETFs – These ETFs often use leverage to reduce the amount of capital they need to invest in an index. The idea is to achieve the same return with less cash invested. An index trading at 2x leverage will, in theory, provide investors with a 2% return if the index returns 1%.

The bottom line on exchange-traded funds

How popular are exchange-traded funds? In 2010, after a run of about 18 years from their inception in the early 1990s, ETF assets finally cracked the one trillion dollar mark. It took them just four years after that to reach two trillion. And in the last year alone, investors have put more than one trillion dollars into ETFs, raising the total amount in ETFs to over $5 trillion.

And it’s easy to see why.

ETFs offer the diversification of index funds and mutual funds but can offer several benefits, especially the liquidity to sell shares of an ETF similar to selling stock. They can be more affordable due to lower transaction costs, they offer greater tax efficiency, and they can provide more complete market coverage.

The good news for investors is that many analysts still believe that with their continued focus on innovation and development, ETFs have a lot of room to evolve.

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