In this week’s post, I explain the basics of exchange traded funds (ETFs).
Exchange traded funds (ETFs) are shares in investment companies, much like mutual funds, which we discussed last week. However, as in their name, exchange traded funds (ETFs) are traded on exchanges, like stocks. ETFs have several attractive features that have resulted in them becoming very popular in the last several decades.
As we have continued to emphasize, remember that investment securities, such as exchange traded funds (ETFs), are distinct from the type of investment account in which they are held, as we covered in a post from several weeks ago. Each type of security has its own characteristics that are separate from the rules and tax treatment of the investment account. This post will explore some of the characteristics of exchange traded funds (ETFs).
Exchange traded funds (ETFs) are shares in investment companies that trade on exchanges, like stocks
In many ways, exchange traded funds (ETFs) are very similar to mutual funds, which we discussed last week. Like mutual funds, ETFs are investment companies that pool investors’ money and then own a variety of underlying securities, such as stocks and bonds.
The biggest difference between ETFs and mutual funds is that shares of ETFs are traded on an exchange, like stocks. As a result of this, shares can be traded at any time during market hours, unlike mutual funds that can only be redeemed through the mutual fund company after the market closes. Even though shares of ETFs trade on an exchange, the underlying holdings do not have to be stocks – the underlying securities can be bonds or other non-stock securities.
There have been some exceptions more recently, but historically ETFs have been passively managed, meaning that their investment objective is to match a particular index, instead of having a manager actively attempt to outperform. Some of these indexes are very broad, such as the S&P500 or DOW. Other indexes are very specific, such as an index tracking a particular industry or sub-segment of the market. A more comprehensive comparison of passive and active management will be the subject of a future blog post.
Here is a visual on the basic ETF structure. You’ll notice that it is very similar to the structure of mutuals funds. The fund is split into different shares. In this example, there are two shares. The fund owns underlying securities that will allow the fund to track its target index. In this example, the ETF owns stock in nine different companies (A through I):
In last week’s post about mutual funds, we discussed the concept of the fund’s “net asset value or “NAV.” The NAV of a mutual fund is the value of all assets that the fund owns, minus any liabilities. ETFs also have an NAV, which is calculated in the same way – adding up the value of all underlying assets of the fund. However, one of the differences between ETFs and open-end mutual funds, is that the price an investor pays or receives when buying or selling a share of an ETF is not the NAV. Rather, the price is set by the market.
With that being said, the price of an ETF is usually very close to the fund’s NAV. Any wide gap will be closed or “arbitraged” away by the market through the share creation process, which we will not cover in detail here. The idea of arbitrage may be the subject of a future post.
In the visual above, the total NAV of the fund is $900. This is calculated by adding up value of the assets ($100 + $50 + $70 + $50 + $100 + $30 + $200 + $125 + $175). This value is then divided by the number of shares to arrive at the NAV per share, which is $450 ($900 / 2). Again, the price of the ETF will be set by market forces, but it will likely be very close to this NAV.
Do ETFs have fees?
Exchange traded funds (ETFs) have yearly management fees, like mutual funds. Because a vast majority of ETFs are passively managed, these fees are typically low, especially when compared to actively managed mutual funds.
What are the benefits of ETFs?
There are several benefits to owning shares of ETFs that we have already touched on:
Ability to trade all day – Because shares of ETFs trade on exchanges, investors can buy and sell at any time during market hours. This has resulted in ETFs being used for day trading and speculation. However, the ability to trade all day also allows investors to precisely rebalance portfolios and make changes at exact prices. For example, especially during times of market turbulence, market prices may change dramatically from one point of time during the day to the market close. ETFs allow portfolio changes at the price the investor actually sees now, not what the price will be at the close, which could be dramatically different.
Low fees – As mentioned above, ETFs typically have low management fees.
Diversification – Similar to mutual funds, one of the main benefits of ETFs is that they are (typically) well diversified. As mentioned last week, diversification is “not putting all your eggs in one basket,” or spreading ownership over many assets so that poor performance of one asset does not destroy the whole portfolio. ETFs typically have many underlying security holdings. This gives investors easy access to diversification that would be hard to replicate on their own.
Are there different styles of ETFs?
As mentioned earlier, there are many different types of ETFs with varying investment objectives. Some ETFs track a broad market index, others track the performance of a particular sector or segment of the market. Many ETFs’ underlying securities are stocks, but others own bonds, preferred stock, or other types of securities.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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