understanding exchange traded funds, etfs

Understanding Exchange Traded Funds (ETFs)

Everyone has heard about mutual funds as a way to get into the market with lower risk. Here, we will go over a similar type of fund, called an ETF, or exchange-traded funds. ETF’s are another excellent low-risk investment opportunity with many similarities to mutual funds, but also distinct differences that make it unique.

In this article will go over the following:

  • The definition of an ETF
  • How an ETF is structured
  • The types of ETFs available
  • Similarities and Differences between ETF’s and Mutual Funds
  • Advantages and Disadvantages of ETFs

What’s an ETF?

To start, let’s define what an ETF is. ETF stands for exchange traded funds. To break it down:

         Exchange-traded means that they are traded on a stock exchange. 

         Fund means that each ETF is a collection of tens, hundreds, or sometimes thousands of stocks, bonds, or commodities.

Thus, putting it all together, an exchange traded fund is a large collection of stocks, bonds, commodities, or assets that are bought and sold on a stock exchange. So, like stocks, they also have their own stock symbol and can be bought/sold throughout any given business day.

What Types Of ETF’s Are Available?

There are many types of ETFs available to you as an investor. Below is a list of the different types and their definitions:

  • Market ETFs: Designed to track a particular index like the S&P 500 or NASDAQ
  • Bond ETFs: Designed to provide exposure to virtually every type of bond available, for instance, U.S. Treasury, corporate, municipal, international, high-yield and several more
  • Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology
  • Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn
  • Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
  • Foreign market ETFs: Designed to track non-U.S. markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index
  • Inverse ETFs: Designed to profit from a decline in the underlying market or index
  • Actively managed ETFs: Designed to outperform an index, unlike most ETFs, which are designed to track an index
  • Exchange-traded notes: In essence, debt securities backed by the creditworthiness of the issuing bank; created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes
  • Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing

Market ETFs are where most passive investing occurs; you purchase your shares and whoever is managing the fund will buy and sell throughout the day, and you pay some small fees for this service. So if you’re interested in ETFs and in mimicking the market, then these are the funds for you.

If you’d like to still mimic the market in regards to the types of stocks in your fund, but would like to try and time the market, then an actively managed ETF is the way to go.

As you can see with all the options, you have the ability to venture out into other areas like commodities and foreign markets and diversify your investments.  While doing so, you still have a low risk and low fee status given the number of commodities and stocks in your funds.

So How Exactly do ETFs work

To start, what exactly is in an ETF? As I mentioned above, it’s a large collection of commodities, stocks, bonds, etc. But the creation of an ETF requires that companies, or issuers, provide shares in their company to the fund.

How do they do this?

Through something called creation units. A creation unit is a collection of anywhere from 25,000 to 600,000 shares of the issuing company, which I’ll refer to as the issuer. The creation unit is then given to a broker-dealer, or an authorized participant(AP).  This is essentially the middle man. Once the creation unit is presented to the broker-dealer, the broker-dealer purchases the creation unit and adds it to the fund. The cost to the broker-dealer is determined by the NAV, or net asset value of the shares. He or she will pay for the creation unit using either a cash exchange or an “in-kind” transaction. 

What’s an in-kind transaction? When the broker-dealer purchases the underlying securities in the creation unit.  They do so proportionally. So if an issuer wants to be 25% of the fund, then the broker-dealer purchases enough securities to exchange “in kind” for a creation unit that will make the fund 25% of that issuer.

If you’re a visual person like me, check out the graphic below to make sense of this:

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However, because ETFs can be traded throughout the day, their price can fluctuate depending on how the market is doing. As we all know, market demand and market pricing can differ from the actual underlying value of a company, asset, or share. To offset this difference that may arise, there is something called the redemption mechanism.

The redemption mechanism is much like it sounds: issuing companies buy back the creation unit in exchange for securities. The way it works is that the AP accumulates enough ETF shares to form the creation unit, and then sells it back to the issuer, who then pays for it using securities. So an in-kind reverse exchange occurs.

 Doing this allows the market price of the ETF to stay in line with the NAV of the fund, thus ensuring that there are no crazy fluctuations or inflated values for the buyers and sellers (like you and me).

This helps de-risk the whole fund as well, because what you see is what you get instead of it being a reflection of public supply and demand.

Again, for all the visual learners, because at some point all the words just blur together, here’s a graphic showing what happens during the redemption process.

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 Another way to think about all of this: the redemption mechanism is basically a process of liquidating shares in the fund.  The more or fewer shares there are, will help either bring down or raise the price per share. So depending on how the underlying value is doing versus the market value, AP’s can start a creation or redemption process that helps reduce discrepancies, leading to a steady price and lower risk for investors.

ETFs vs Stocks & Mutual Funds

So we’ve gone over the definition, the types, and how exactly an ETF is put together and managed, now let’s compare ETFs with other comparable investment options that you may see as an individual investor. 

ETF vs Individual Stocks

ETFs carry less risk than stocks.  Because an ETF is a mixed collection of stocks and bonds, for example, when one individual company stock does poorly, it does little to affect the fund as a whole. The other stocks provide a buffer and minimize your losses. In contrast, when you purchase an individual stock, and it does poorly, there is no buffer.  Your monetary loss is proportional to the loss of the stock value.

In addition, because of its low-risk, all-inclusive nature, you may save time when investing in ETFs, especially market ETFs, because you don’t have to individually research companies, or have to worry about their individual performance as much.

 ETF vs a Mutual Fund

ETFs and mutual funds share many similarities, including that they are both a “collection of stocks, bonds, commodities, etc.”.  They are both low risk, have low brokerage fees and you can easily find options in both that allow you to invest at home and abroad.

However, there are some key differences including:

Lower investment minimums – to start buying into an ETF there’s either no minimum or a low threshold to reach, versus mutual funds that may require more funds upfront to get started.  However, once you get started, there is no minimum amount for either ETF or mutual funds to continue investing.

ETFs give you Real-Time Pricing (the redemption mechanism at work!) and also the ability to buy and sell throughout the day. As a result, an ETF has the upper hand of being able to take advantage of any price fluctuations that may occur.

Because they are traded like stocks, investors can place a variety of types of ETF orders (limit orders, stop-loss orders, buy on margin), which are not possible with mutual funds.

Finally, an ETF may prove to be more tax-efficient as investors have better control over when they pay capital gains taxes.

To break it down further, depending on what your goals are for investing, here are some side-by-side comparisons of the differences between mutual funds and ETFs. 

GoalETFsMutual Funds
Lower investment minimumUsually, no minimum to enter. You can buy 1 ETF at its market priceUsually needs a minimum upfront investment to enter into the fund, irrespective of the share price. E.g., Vanguard usually has a $3000 minimum and you would get the number of shares based on share price.
Want to control price you pay per shareProvides real-time pricing, different order types available to choose from so that you can try to get the best price per shareCan only get the price that’s determined at the end of the market day. Cannot take advantage of daily fluctuations
Want to automate transactionsCannot make automatic withdrawals or investmentsCan make automatic withdrawals or investments
Want Index fundsYes, ETF index funds are availableYes, Mutual fund index funds are available
Tax savingsIncur lower capital gains taxes, as capital gain only occurs with a saleCapital gains are incurred throughout the life of the fund i.e. there are more gains, thus more taxes

Advantages of ETFs

Lower Investment Minimums

As mentioned above, there’s usually not a minimum buy-in to start trading with an ETF.

Trading Flexibility

Because you can buy and sell throughout the day, you can take advantage of price dips to get more for your money.

Diversification

With so many types of ETFs to choose from, you can easily diversify your portfolio and try your hand at different commodities and new markets while maintaining a low-risk profile.

Low Costs

Most funds have very low operating costs; therefore the cost to you to invest, in regards to the fees required, is very low.

Tax Savings

ETFs are taxed in two ways: capital gains tax and dividends. 

Capital gains taxes are only incurred once a sale is made. So the less you sell, the less you pay, which also gives you control over the timing of capital gains accumulation. 

Next, dividend payouts are either qualified or unqualified.  Qualified dividends have a lower tax rate. With unqualified, you’ll be taxed at your current income tax rate. To be considered as “qualified”, you must hold an ETF for 60 days prior to dividend payout.

Disadvantages of ETFs

There are some disadvantages of ETFs to be aware of.

Delayed Settlements

Even though ETFs are great in being able to take advantage of their real-time pricing, the sales are not settled for 2 days following a transaction. In other words, if you sell shares and want to turn around and buy new, you have to wait 2 days in order for those funds from the sale to be available. 

Trading Costs

At small investment amounts, the cost to you may not be worth entering an ETF. Instead, you may find lower-cost alternatives by investing with a fund company in a no-load (fees) fund.

Technical Issues

While an AP has the ability to buy and sell creation units to keep the price of the fund in line with the NAV, technical issues may occur that create discrepancies leading to the inability to track the underlying price appropriately.

Possibility of Large Discrepancies

With the creation/redemption mechanism, discrepancies in the funds NAV and the price per share are usually very small.  However, smaller niche funds may have larger gaps in pricing (aka the bid/ask spread).

Fee Creep

Watch the fees of the fund you’re purchasing. Some ETFs may have a waiver to temporarily offer lower expense ratios to investors (termed the “net expense ratio”).  These waivers are usually extended, but the fund sponsor may decide to allow the waiver to expire. In which case, the expense ratio will increase from the “net” amount to a higher “gross” amount. 

Key Takeaways

Hopefully, the above information helps you to make a more informed decision about ETFs and the type you’d want to invest in.

To summarize some take-home points:

  • ETFs are low risk due to the creation and redemption of shares
  •  ETFs are low cost to the investor, but still make sure you watch those fees!
  • You can easily diversify your portfolio with the different kinds of ETFs available to you
  • Most ETFs allow for passive investing, yet because they are actively traded you can hope to get the best market price
  • You should choose between ETFs and mutual funds based on your investment goals

Final Thoughts

Exchange traded funds are an excellent way to diversify and derisk your investments. The beauty of these funds, too, is that your investment remains liquidable. So, you can easily experiment with different funds and pull out your money at any time. Do your research to see which ones interest you and align with your investment goals!

Happy investing!

Featured image courtesy of unsplash.