An exchange-traded fund (ETF) is an investment fund that tracks the performance of a basket of assets, such as stocks, bonds, or commodities. It can be traded on an exchange like a stock.
Capital markets specialist Damien Sherman says that ETFs are low-cost in several ways.
“The trading of them is very efficient,” he explains. “The more trading that goes through, the more the spreads. That’s the cost of trading compressors.”
He adds that putting money to work in a fund is not a costless exercise.
“If you take $100 and put it in into a fund, and the manager needs to take that $100 and put it to work, then it doesn’t end up in the fund at work at $100. There’s a cost involved with that, and ETFs really reduce that cost.”
When an investor buys shares of an ETF, they are purchasing a slice of the underlying assets held by the fund. The issuer creates new shares of the ETF and sells them to investors in exchange for cash or other securities. The ETF shares are then listed on an exchange and can be traded throughout the day, just like stocks.
The value of the ETF shares is based on the net asset value (NAV) of the underlying assets held by the fund. The NAV is calculated by adding up the market value of the fund’s assets and dividing it by the number of shares outstanding. As the value of the underlying assets fluctuates, so does the NAV of the ETF.
ETFs offer several advantages over traditional mutual funds. First, ETFs can be bought and sold throughout the trading day, unlike mutual funds, which are priced only once at the end of the trading day. This allows investors to react quickly to market movements and take advantage of intraday trading opportunities.
Second, ETFs typically have lower fees than mutual funds. This is because ETFs do not have to be actively managed like mutual funds, which require a team of investment professionals to buy and sell securities on behalf of investors. Instead, ETFs are typically passively managed, meaning they track the performance of an underlying index.
Third, ETFs offer greater flexibility than mutual funds. Investors can buy and sell ETFs like stocks, which means they can place limit orders, short sell, or trade on margin. This makes ETFs popular for active traders and investors who want to take advantage of market volatility.
Overall, ETFs are a popular investment vehicle because they offer investors the benefits of diversification, low costs, and flexibility. By tracking the performance of a basket of assets, ETFs allow investors to gain exposure easily and cost-effectively to different markets and sectors.
The structure of ETFs
Most ETFs are structured as open-end funds, meaning that the ETF issuer creates and redeems ETF shares as needed in response to investor demand. Here’s how the structure of an ETF typically works:
- Creation: The ETF issuer creates new shares of the ETF by buying a basket of securities representative of the underlying index the ETF is tracking. The issuer then transfers those securities to a custodian bank in exchange for ‘creation units’ of the ETF, which are large blocks of shares.
- Redemption: When an investor wants to sell shares of the ETF, the ETF issuer redeems the shares by giving the investor the underlying securities that the ETF holds. The issuer then cancels the redeemed shares and returns the creation units to the custodian bank.
- Market trading: ETF shares are traded on an exchange like stocks, so the price of the ETF may differ from the underlying NAV. When the demand for an ETF increases, the price may rise above the NAV, leading authorised participants to buy the underlying securities and create new ETF shares. When the demand for an ETF decreases, the price may fall below the NAV, leading authorised participants to redeem shares and sell the underlying securities.
- Portfolio management: The ETF is managed by an investment advisor who aims to track the performance of the underlying index by adjusting the ETF’s portfolio of securities as needed. Passive ETFs typically aim to replicate the performance of the underlying index, while active ETFs may use a range of strategies to try to outperform the index. There can be a difference in the trading value between the underlying investment value calculated by a unit price approach that managed funds use and the live share price of an ETF.
Who are the key players?
The ETF industry involves several other key players who perform different roles to ensure that the ETF operates smoothly and efficiently.
The manager of an ETF is typically a registered investment adviser who is responsible for overseeing the ETF’s daily operations, managing the ETF’s portfolio of securities, and ensuring that the ETF complies with applicable regulations. The manager may also work with the ETF’s custodian to handle the creation and redemption of ETF shares.
The investment adviser is responsible for designing the investment strategy of the ETF and making investment decisions on behalf of the ETF. In some cases, the adviser may be a separate entity from the manager; in others, the adviser and the manager may be the same entity.
Market makers play a critical role in the ETF industry by providing liquidity and helping to ensure that ETF shares can be bought and sold at fair prices. Market makers are typically registered broker-dealers with authority to create and redeem ETF shares directly with the issuer. They also provide quotes for buying and selling ETF shares throughout the trading day, helping to keep the ETF’s market price in line with its underlying net asset value (NAV).
