28 Oct 2018

DEFINITION of ‘Exchange-Traded Fund (ETF)’

An ETF, or exchange-traded fund, is a marketable security that tracks a stock index, a commodity, bonds, or a basket of assets. Although similar in many ways, ETFs differ from mutual funds because shares trade like common stock on an exchange. The price of an ETF’s shares will change throughout the day as they are bought and sold. The largest ETFs typically have higher average daily volume and lower fees than mutual fund shares which makes them an attractive alternative for individual investors.

While most ETFs track stock indexes, there are also ETFs that invest in commodity markets, currencies, bonds, and other asset classes. Many ETFs also have options available for investors to use income, speculation, or hedging strategies.

BREAKING DOWN ‘Exchange-Traded Fund (ETF)’

An ETF is a type of fund that owns underlying assets (shares of stock, bonds, oil futures, gold bullion, foreign currency, etc.) and divides ownership of those assets into shares. Most ETFs are set up as an open-ended fund and (in the U.S.) are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements.

Some ETFs are established as Unit Investment Trusts (UIT) which technically must have a date set in the future when the fund will end. In fact, the largest and oldest ETF S&P 500 ETF) is one of the few ETFs set up as a UIT. However, because an ETF that is set up as a UIT can extend that date perpetually, they act very similarly to standard open-ended funds. A grantor-trust is sometimes considered a type of ETF but, because it conveys direct ownership of the fund’s assets to its shareholders, these are usually not considered a true ETF.

ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in case the fund is liquidated. An ETF is more tax efficient than a mutual fund. This is because most buying and selling occurs through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell, or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares they sell it back to the fund, and a tax liability can be created that must be paid by the shareholders of the fund.

The average expense ratio among mutual funds has been falling over the last two decades largely from pressure brought by low-cost ETFs. The average annual expense ratio for stock ETFs was .23% and .20% for bond ETFs in 2016. Some of the largest indexed ETFs have expense ratios near .10%. The average passively indexed stock mutual fund had an expense ratio of .59% in 2016. The lower costs of ETFs are one of the biggest reasons the market for these instruments has grown so quickly.

ETF Creation and Redemption

The supply of ETF shares is regulated through a mechanism known as creation and redemption, which involves large specialized investors, called authorized participants (APs). An AP can redeem ETF shares by selling them back to the fund’s sponsor. Selling assets (stocks, bonds, etc.) to the ETF sponsor, in return for shares in the ETF, is called creation. The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of its assets.

ETF Creation when Shares Trade at a Premium – Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of market. If the value of the stocks that the ETF owns was only worth $100 on a per share basis then the fund is trading at a premium to its Net Asset Value (NAV).

An authorized participant has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy the shares that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF. In this exaggerated example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.

ETF Redemption when Shares Trade at a Discount – Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks the ETF is holding in the fund are worth $100 per share then the ETF is trading at a discount to NAV.

To bring the ETF’s share price back to its NAV, an AP will buy shares of the ETF on the open market and sell them back to the ETF in return for shares of the underlying stock portfolio. This is an exaggerated example, but theoretically, this means the AP is able to buy ownership of $100 worth of stock in exchange for ETF shares it bought for $99. This process is called redemption and it decreases the supply of ETF shares on the market. When the supply of ETF shares is decreased the price should rise and get closer to its NAV.

How to Trade ETFs

ETFs can be traded through online brokers and traditional broker-dealers. Robo-advisors like Betterment also make use of ETFs in their investment products.

Advantages and Disadvantages of ETFs

ETFs provide other benefits in addition to lower average costs and tax efficiency. By owning an indexed stock ETF, investors get the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share (there are no minimum deposit requirements). Some brokers even offer no-commission trading on certain low-cost ETFs, which can keep costs even lower for small investors.

Not all ETFs are equally diversified. Some may have a very heavy concentration in just one stock or asset, or a small group of stocks and assets that are very highly correlated. Actively managed ETFs may offer higher potential returns but they are also more expensive and might not meet expectations. Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

Many notable investors have raised concerns about the influence of ETFs on the market and whether demand for these funds can inflate stock values into fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds which have a negative impact on market stability.

Leveraged and Inverse “ETFs”

Some ETFs recreate a portfolio that uses margin to short stocks or other assets (inverse) or use margin to increase leverage. Most of these types of securities are Exchange Traded Notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank. These instruments are frequently referred to as an ETF but are only designed to replicate the return of whatever asset they are tracking. On average, ETNs are more expensive than ETFs and include the credit risk that the issuer will be unable to back the ETN during a period of market stress.

Examples of Widely Traded ETFs

  • S&P 500 (SPY): The oldest surviving and most widely known ETF tracks the S&P 500 Index
  • iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index and is extremely popular among option traders
  • Invesco QQQ (QQQ): Indexes the Nasdaq 100
  • SPDR Dow Jones Industrial Average (DIA): Represents the 30-stocks of the Dow Jones Industrial Average
  • Sector ETFs: Track individual industries such as oil (OIH), energy (XLE), financial (XLF), REITs (IYR), Biotech (BBH), and so on
  • Commodity ETFs: Represent commodity markets including crude oil (USO) and natural gas (UNG)
  • Physically-Backed ETFs: The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold actual gold and silver bullion in the fund

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