Exchange traded fund

What Is an Exchange Traded Fund?

An exchange traded fund (ETF) is a type of investment product that holds a collection of underlying assets, such as stocks, bonds, or commodities, and trades on public stock exchanges like individual securities. Unlike traditional mutual funds, which are priced only once per day after the market closes, ETFs can be bought and sold throughout the trading day at market-determined prices. This structure places ETFs within the broader category of investment products and, from a strategic perspective, aligns them with principles of portfolio theory, often facilitating diversification. An exchange traded fund provides investors with exposure to a basket of assets without needing to purchase each component individually, making them a popular choice for both institutional and retail investors.

History and Origin

The concept of an exchange traded fund emerged as a response to the limitations of traditional investment vehicles. While similar products existed in Canada, the first exchange traded fund in the United States, the SPDR S&P 500 ETF Trust (SPY), began trading in 1993. This innovation allowed investors to gain exposure to a broad market index with the trading flexibility of a single stock.

For many years, the U.S. Securities and Exchange Commission (SEC) regulated ETFs primarily through individualized exemptive orders under the Investment Company Act of 1940, a process that could be time-consuming and costly for fund issuers. To modernize and streamline the regulatory framework, the SEC adopted Rule 6c-11 in September 2019. This "ETF Rule" established a consistent set of requirements for most ETFs, allowing them to come to market more quickly without needing specific exemptive relief. The rule aims to facilitate greater competition and innovation in the exchange traded fund marketplace, ultimately providing more choices for investors⁸, ⁹.

Key Takeaways

• An exchange traded fund is a marketable security that tracks an index, commodity, bonds, or a basket of assets, trading like a common stock on a stock exchange.
• ETFs offer diversification across various asset classes and market segments, often at a lower expense ratio compared to actively managed mutual funds.
• The price of an exchange traded fund fluctuates throughout the trading day, reflecting real-time market supply and demand, unlike mutual funds that are priced once per day based on their net asset value (NAV).
• ETFs incorporate a unique creation and redemption mechanism involving authorized participants and an arbitrage process, which helps keep their market price closely aligned with their underlying NAV.
• They provide tax efficiency compared to traditional mutual funds, particularly concerning capital gains distributions.

Formula and Calculation

The value of an exchange traded fund is derived directly from the collective market value of its underlying holdings. Therefore, there is no specific "formula" in the traditional sense that calculates an ETF's performance or intrinsic value beyond the sum of its constituents.

However, a key concept related to an exchange traded fund's pricing is its Net Asset Value (NAV) per share, which is calculated as:

While the NAV is calculated once per day at market close, an ETF's market price can fluctuate throughout the day based on supply and demand on the exchange. The arbitrage mechanism involving authorized participants generally ensures that the market price remains very close to the NAV, preventing significant premiums or discounts.

Interpreting the Exchange Traded Fund

Interpreting an exchange traded fund involves understanding its investment objective, the assets it holds, and its performance relative to its benchmark. Since most ETFs are designed to track specific indexes, their performance is typically evaluated by how closely they replicate the returns of that index. This concept is known as tracking error. A lower tracking error indicates that the exchange traded fund is effectively mirroring its intended benchmark.

Investors often use ETFs to gain broad market exposure, target specific sectors, or implement various investment strategies. For example, an investor might use a bond ETF to gain exposure to fixed income markets, or a gold ETF to invest in commodities. Understanding the underlying holdings and the fund's investment strategy is crucial for proper interpretation.

Hypothetical Example

Consider an investor, Sarah, who wants to gain exposure to the technology sector but doesn't want to research and purchase individual tech stocks. Instead, she decides to invest in a hypothetical "Tech Innovators Exchange Traded Fund" (TIEF).

1. Objective: TIEF's objective is to track a custom index of 50 leading technology companies.
2. Purchase: Sarah opens a brokerage account and places an order to buy 100 shares of TIEF at its current market price of $150 per share. Her total investment is $15,000 (excluding trading commissions, if any).
3. Underlying Assets: Each share of TIEF represents a proportional ownership in the diversified portfolio of 50 tech stocks held by the fund. If one tech stock performs poorly, its impact on Sarah's overall investment is mitigated by the performance of the other 49 stocks, illustrating the diversification benefit.
4. Market Fluctuations: Throughout the day, as the prices of the underlying tech stocks change, the market price of TIEF will also fluctuate. Sarah can monitor her investment in real-time.
5. Distributions: Over time, TIEF may pay out dividends from the underlying stocks it holds, which Sarah would receive proportionally to her share ownership.

This example illustrates how an exchange traded fund offers a convenient and diversified way for Sarah to invest in a specific market segment without managing individual securities.

Practical Applications

Exchange traded funds are widely used across the financial landscape by various types of investors for numerous purposes:

• Portfolio Diversification: ETFs tracking broad market indexes (e.g., S&P 500) offer immediate diversification across many stocks or bonds with a single purchase.
• Sector and Industry Exposure: Investors can target specific sectors (e.g., technology, healthcare) or industries without having to select individual companies.
• Asset Allocation: ETFs allow for efficient allocation across different asset classes, such as equities, fixed income, real estate, and commodities.
• International Investing: ETFs provide access to foreign markets and regions, simplifying international diversification and currency exposure.
• Tactical Trading: The intra-day trading capability of ETFs makes them suitable for tactical allocation strategies and short-term market plays, allowing investors to react quickly to market movements.
• Low-Cost Investing: Many ETFs, particularly those tracking broad indexes, have very low expense ratios, making them a cost-effective investment vehicle.
• Facilitating Capital Flows: ETFs play a significant role in international capital flows, especially to emerging markets. Research suggests that the growth of ETFs as a conduit for capital flows to emerging economies has amplified the transmission of global financial shocks to those economies, partly due to the specific types of investors who favor ETFs for their liquidity and passive management⁷.

Limitations and Criticisms

Despite their widespread adoption and benefits, exchange traded funds are not without limitations and criticisms:

• Tracking Error: While ETFs aim to mirror their underlying indexes, perfect replication is rarely achieved. Factors such as management fees, rebalancing costs, and dividend timing can lead to a "tracking error," where the ETF's performance deviates slightly from its benchmark⁶.
• Trading Costs: Although many ETFs offer low expense ratios, investors incur brokerage commissions when buying and selling shares, similar to stocks. Frequent trading can accumulate these costs, potentially eroding returns⁵.
• Market Price vs. NAV: While the arbitrage mechanism generally keeps the market price of an exchange traded fund close to its net asset value, significant deviations can occur during periods of high market volatility or low liquidity in the underlying assets.
• Complexity of Certain ETFs: The proliferation of specialized ETFs, such as leveraged, inverse, or actively managed non-transparent funds, introduces increased complexity and unique risks that may not be suitable for all investors. Investors in such products must fully understand their underlying mechanics⁴.
• Concentration Risk: Some thematic or highly specialized ETFs may hold concentrated portfolios, making them more dependent on the performance of a small subset of stocks and introducing higher "active risk" compared to broad-market funds. Investors should scrutinize any ETF with fewer than 100 holdings³.
• Systemic Risk Concerns: Some critics have raised concerns about the potential for ETFs to contribute to systemic risk, particularly during periods of market stress. However, experts like Ben Johnson, global ETF research director for Morningstar, argue that ETFs themselves do not create risk; rather, investors' behavior can lead to volatility². Morningstar also highlights risks such as counterparty risk in synthetic ETFs and the general risks of concentrated portfolios¹.

Exchange Traded Fund vs. Mutual Fund

The exchange traded fund and the mutual fund are both popular investment vehicles that pool money from multiple investors to invest in a diversified portfolio of securities. However, fundamental differences exist in how they are traded, priced, and structured:

The choice between an exchange traded fund and a mutual fund often depends on an investor's trading frequency, cost sensitivity, and preference for real-time pricing versus end-of-day pricing.

FAQs

What assets can an Exchange Traded Fund hold?

An exchange traded fund can hold a wide range of assets, including stocks, bonds, commodities like gold or oil, currencies, or even a mix of these. The specific assets depend on the ETF's investment objective and the index or strategy it aims to track.

Are Exchange Traded Funds diversified?

Most exchange traded funds are inherently diversified, as they hold a basket of underlying securities rather than just one. This built-in diversification helps spread risk across multiple holdings. However, specialized or highly concentrated ETFs may offer less diversification than broad market funds.

How do I buy an Exchange Traded Fund?

To buy an exchange traded fund, you typically need a brokerage account. Once you have an account, you can place an order for ETF shares through your broker, just as you would buy or sell individual stocks. Their prices fluctuate throughout the trading day.

What is the expense ratio for an Exchange Traded Fund?

The expense ratio of an exchange traded fund is the annual fee charged by the fund provider as a percentage of the assets under management. It covers the fund's operating expenses, such as management fees and administrative costs. ETFs are generally known for their relatively low expense ratios, especially compared to actively managed mutual funds.