What Are ETFs?

By Daren Fonda

         Photo: Fabio Ballasina 

Exchange-traded funds are similar to mutual funds: Both hold baskets of individual stocks, bonds, or other investments. ETFs are called “exchange-traded” because investors can buy or sell them on a stock exchange, just like shares of a publicly traded company.

ETF prices fluctuate with the value of their holdings. Investors can trade ETFs as frequently as they like. And ETFs are hugely popular among hedge funds, institutional traders, and individual investors. These funds now account for almost 22% of the volume on the New York Stock Exchange, with 1.2 billion shares changing hands on an average day. 
Mutual funds, in contrast, aren’t geared for trading. Funds are only available at their net asset value (excluding any commissions or fees), calculated after the market closes at 4 p.m. every day. Many mutual funds also impose minimum holding periods of 30 days to prevent investors from dipping in and out over a short period.

What do ETFs invest in?

In most cases, ETFs are index-based stock funds: their goal is to mirror the performance of a market benchmark such as the Standard & Poor’s 500 index. That was the objective of the first ETF, the SPDR S&P 500 (ticker: SPY), which hit the market in 1993. Holding more than $270 billion in assets, SPY remains the largest ETF. But it’s now one of more than 1,850 ETFs, holding a combined $3.6 trillion in assets.

While some exchange-traded funds track traditional indexes, most mirror custom-made ones, focused on, say, large-cap growth stocks, small-cap value equities, or high-yield bonds. These indexes may target a sector, such as industrials, or a sliver of a sector, such as consumer-related internet stocks. Other ETFs cover everything from foreign stock markets to real-estate investment trusts, energy master limited partnerships, and preferred shares.

A new class of ETFs called “smart beta” has emerged lately. These aim to beat traditional market-cap weighted indexes by emphasizing stocks with certain attributes, such as low price/earnings ratios, momentum in their share prices, or strong company fundamentals (such as high returns on equity).  

Beyond stock and bond ETFs lies a realm of alternative funds. Leveraged ETFs, for instance, borrow money to boost their exposure to an investment by up to three times a standard amount (on a daily basis). Inverse ETFs, which may also use leverage, wager against the market, sectors or asset classes such as currencies. These can be complicated and risky, especially for inexperienced investors.  
Exchange-traded notes also exist. These are issued by banks and other financial firms, ETNs are debt securities that aim to mimic the returns of an index (less fees). Most ETNs focus on alternative assets, such as commodities, currencies, and master limited partnerships. The largest ETN, the iPath Bloomberg Commodity Index Total Return (DJP), offers exposure to a broad basket of commodities. ETNs aren’t taxed the same as ETFs, however, and, as debt securities, they pose a risk that the issuer may default, potentially wiping out shareholders.

How are ETFs made?

When investors buy shares in a mutual fund, they essentially hand over cash to a fund sponsor, which issues shares as money flows in and redeems them when investors cash out. That’s why most mutual funds are “open-ended.”

ETFs don’t have a fixed number of shares. Instead, their shares are created and redeemed by middlemen—big institutional investors called “authorized participants.” AP will buy a block of the ETF’s underlying holdings—say shares of every stock in the S&P 500—in the same proportion as the ETF holds them. The AP exchanges the securities for a “creation unit”—typically a block of 100,000 ETF shares—and then sells them on the open market. To remove ETF shares from the market, the process works in reverse: The AP buys enough shares to form a creation unit, delivers it to the fund’s sponsor and receives a basket of underlying securities in return.

This creation-redemption process keeps the share price of an ETF in line with its net asset value. If demand for an ETF pushes the share price above the NAV, the AP will issue more creation units, increasing supply and pushing the price closer to the NAV. Conversely, the AP can remove ETF shares from the market through the redemption process if the price drops much below NAV, thereby pulling the price back up.

That arbitrage mechanism doesn’t work perfectly—it can short-circuit during periods of extreme volatility and for funds holding thinly traded assets. Bond ETFs are particularly susceptible to trading at discounts or premiums because most bonds don’t trade on an exchange and some might not trade for weeks at a time, making it harder to ascertain a bond portfolio’s “intrinsic value,” says Dave Nadig, managing director of ETF.com. Nonetheless, for major ETFs, the arbitrage process generally ensures that wide discrepancies between the share price and NAV are rapidly traded away.

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