What is an Exchange-Traded Fund (ETF)?
An Exchange-Traded Fund (ETF) is an investment fund that holds assets such as stocks, commodities, bonds, or foreign currency. An ETF is traded like a stock throughout the trading day at fluctuating prices. They often track indexes, such as the Nasdaq, the S&P 500, the Dow Jones, and the Russell 2000. Investors in these funds do not directly own the underlying investments, but instead, have an indirect claim and are entitled to a portion of the profits and residual value in case of fund liquidation. Their ownership shares or interest can be readily bought and sold in the secondary market.
What are the Different Types of ETFs?
There are many types of Exchange-Traded Funds. Some of the most common ETFs include:
Stock ETFs – these hold a particular portfolio of equities or stocks and are similar to an index. They can be treated like regular stocks in that they can be sold and purchased for a profit, and are traded on an exchange throughout the trading day.
Index ETFs – these mimic a specific index, such as the S&P 500 Index. They can cover specific sectors, specific classes of stocks, or foreign or emerging markets equities.
Bond ETFs – an exchange-traded fund that is specifically invested in bonds or other fixed-income securities. They may be focused on a particular type of bonds or offer a broadly diversified portfolio of bonds of different types and with varying maturity dates.
Commodity ETFs – hold physical commodities, such as agricultural goods, natural resources, or precious metals. Some commodity exchange-traded funds may hold a combination of investments in a physical commodity along with related equity investments – for example, a gold ETF might have a portfolio that combines holding physical gold with stock shares in gold mining companies.
Currency ETFs – these are invested in a single currency or a basket of various currencies and are widely used by investors who wish to gain exposure to the foreign exchange market without directly trading futures or the forex market. These exchange-traded funds usually track the most popular international currencies such as the U.S. dollar, Canadian dollar, Euro, British pound, and Japanese yen.
Inverse ETFs – An inverse exchange-traded fund is created by using various derivatives to gain profits through short selling when there is a decline in the value of a group of securities or a broad market index.
Actively Managed ETFs – these ETFs are being handled by a manager or an investment team that decides the allocation of portfolio assets. Because they are actively managed, they have higher portfolio turnover rates compared to, for example, index funds.
Leveraged ETFs – Exchange-traded funds that mostly consist of financial derivatives that offer the ability to leverage investments and thereby potentially amplify gains. These are typically used by traders who are speculators looking to take advantage of short-term trading opportunities in major stock indexes.
Real Estate ETFs – These are funds invested in real estate investment trusts (REITs), real estate service firms, real estate development companies, and mortgage-backed securities (MBS). They may also hold actual physical real estate, including anything from undeveloped land to large commercial properties.
What are the Advantages of Investing in an ETF?
There are many advantages to investing in an Exchange-Traded Fund, including the following:
Lower transaction costs and fees: ETFs typically have significantly lower expense ratios than a comparable mutual fund. This is, in part, because of their exchange-traded nature, which places typical costs on the brokers or the exchange, in comparison with a mutual fund, which must bear the cost in aggregate.
Accessibility to markets: ETFs have led the advent of exposure to asset classes that were previously hard for individual retail investors to access, such as emerging markets equities and bonds, gold bullion or other commodities, and the foreign exchange (forex) market and cryptocurrencies. Because an exchange-traded fund can be sold short and margined or leveraged, it can offer opportunities to utilize sophisticated trading strategies.
Transparency: Hedge funds and even mutual funds operate in a not-so-transparent manner compared to ETFs. Hedge funds, institutional investors, and mutual funds usually report their holdings only on a quarterly basis, leaving investors without an idea of whether the fund is following its stated investment strategy and adequately managing risks. In contrast, ETFs generally disclose their daily portfolios, which helps the investor maintain better awareness of exactly how his or her money is being invested.
Liquidity and Price Discovery: Because they can be bought or sold in secondary markets throughout the day, ETFs are more liquid than mutual funds, which can only be bought or sold at their end-of-day closing price. They usually trade close to their true Net Asset Value, as their mechanism of creation/redemption constantly balances out the arbitrages in pricing, continually bringing the price of ETF shares back to fair market value.
Tax Efficiency: Generally, in an after-tax consideration, ETFs pose a major advantage over mutual funds for two main reasons. First, ETFs reduce portfolio turnover and offer the ability to avoid short-term capital gains (which entail high tax rates) by doing in-kind redemptions. Second, ETFs can overcome rules that prohibit selling and realizing (claiming) a loss on a security if a very similar security is bought within a 30-day window.
Drawbacks of Exchange-Traded Funds
Despite the abovementioned benefits, ETFs encounter some challenges as well. For instance, they provide higher exposure to previously unattended asset classes that could entail risks that equity investors might not be familiar with. Ease of access may work against the general public if taken lightly. Some sophisticated examples, such as alternative ETFs, involve complex or unfamiliar portfolio structures, tax treatments, or counterparty risks, which require a deeper understanding of the underlying assets.
Additionally, ETFs carry transaction costs that should be carefully considered in the process of portfolio creations such as Bid/Ask spreads and commissions.
Who are the biggest ETF management companies?
As of 2017, there are thousands of Exchange-Traded Funds in existence. If you want to know who the largest fund management companies in the world are, here is a list of the top 10 fund companies ranked by assets under management (from etf.com).
- State Street Global Advisors
- Invesco PowerShares
- Charles Schwab
- First Trust
Who are the Authorized Participants in an ETF?
A unique feature of an Exchange-Traded Fund is that it has Authozied Participants who help facilitate the market for fund units.
As per regulatory directives, Authorized Participants (APs) are designated to create and redeem ETFs. APs are large financial institutions that have huge buying power and market makers, such as large broker-dealers and investment banks and companies. In creating the fund, APs assemble the required portfolio of asset components and turn the basket over to the fund in exchange for a number of newly created ETF shares. When the need for redemption arises, APs return the ETF shares to the fund and receive the portfolio basket. Individual investors can participate by using a retail broker who trades in the secondary market.
ETF Creation/Redemption Process
ETFs involve a process of Creation/Redemption, which is the lifeblood of these types of securities, and is the main differentiator from equities, as ETFs don’t start trading on a stock exchange by means of an Initial Public Offering.
The continuous mechanism by which ETFs operate works as follows:
- Large institutional investors, known as Authorized Participants (APs) who are large market makers, are the only investors who can create or redeem new shares of an ETF. They create new shares of an ETF by transacting with the ETF manager.
- On the other hand, the ETF manager communicates which shares it wants to own in the fund (e.g., an ETF tracking SP/TSX will want to own all the securities and in the same weight as those contained in the index). This is known as the creation basket.
- The APs go to the market and buy the stocks in the creation basket in the right percentages, or uses the shares it holds, and delivers this representative basket of securities to the ETF for an equal amount (value) in shares of the ETF. The process can work inversely, which means that an AP that has a block of the ETF can transact it with the ETF manager and receive the equal basket of underlying securities. This second basket is called the redemption basket and is usually the same as the creation basket unless the ETF manager is trying to get rid of a specific set of securities.
This process occurs in large blocks called creation units, often equalling 50,000 shares of the ETF, in a one-to-one rate, one basket of the underlying stocks in exchange for one basket of ETF shares.
As the creation basket is disclosed at the beginning of the day and is available to all market participants, the arbitrage gap varies according to the liquidity of the securities and implied costs, but generally makes the price of the ETF to be near its fair market value.
Example Exchange-Traded Fund Creation/Redemption
To better illustrate this process, consider the following example:
Example: ETF Share creation
Price of ETF trading on the exchange: $32.15
Fair Market Value of the ETF based on its underlying securities: $32.00
If this is the case, an Authorized Participant (AP) will want to buy the creation basket (the underlying stocks) and will pay $32.00 and exchange it with the ETF manager for a part of the creation unit. The AP now has shares of the ETF that it can sell in the market at the market price of $32.15 and profit $0.15 per share.
In turn, this process exerts downward pressure on the price of the ETF and upward pressure on the price of the underlying stocks, until no further arbitrage can be made. For illustrative purposes, this example doesn’t account for AP costs such as trading and fees, as well as hedging costs for cases in which blocks are demanded partially.
Because of the versatility, liquidity, and low trading costs that ETFs offer, they are an increasingly popular investment vehicle. Investors are urged to explore the large, varied offerings of ETFs, and to consider making ETF investments a mainstay of their overall investment portfolio.