Exchange traded fund shares

What Is Exchange Traded Fund Shares?

Exchange traded fund shares are individual units of an exchange-traded fund (ETF) that trade on stock exchanges, much like individual securities. ETFs are a type of investment vehicles that hold a basket of assets, such as stocks, bonds, or commodities, and aim to track the performance of an underlying index or a specific sector. Unlike traditional mutual funds, whose shares are bought and sold directly from the fund company at the end of the trading day, exchange traded fund shares can be traded throughout the day at market-determined prices. This characteristic offers investors flexibility and real-time pricing for their portfolio allocations, providing a tool for instant diversification.

History and Origin

The concept of exchange traded fund shares emerged from a need for a liquid, diversified investment product that could be traded continuously. While earlier attempts at index-tracking instruments existed, the first successful U.S.-listed ETF was the SPDR S&P 500 ETF (SPY), launched by State Street Global Advisors in January 1993. This innovation followed market turbulence, particularly the "Black Monday" crash of 1987, which prompted regulators to consider new types of securities that could represent broad market exposure more effectively. The Securities and Exchange Commission (SEC) expressed interest in developing such a vehicle, believing it could potentially mitigate future market disruptions.⁸ This led to a collaboration between State Street and the American Stock Exchange (AMEX), culminating in the debut of SPY, which tracked the S&P 500 Index.⁷ The introduction of exchange traded fund shares marked a significant milestone, democratizing access to markets previously less accessible to many investors.⁶

Key Takeaways

• Exchange traded fund shares are investment units that trade on stock exchanges throughout the day.
• They represent a fractional ownership in a diversified basket of assets held by the ETF.
• Unlike mutual funds, ETF shares are priced continuously by the market, not just once a day at their net asset value.
• Their tradability and diversification benefits have made them popular tools for both institutional and individual investors.
• The primary market mechanism involving authorized participants helps keep the market price of exchange traded fund shares aligned with the value of their underlying assets.

Interpreting Exchange Traded Fund Shares

Interpreting exchange traded fund shares primarily involves understanding their market price in relation to the net asset value (NAV) of the underlying assets. Because exchange traded fund shares trade on an exchange, their price can fluctuate based on supply and demand, potentially creating a slight premium or discount to the ETF's NAV. While these deviations are usually small due to the arbitrage activities of market participants, understanding this dynamic is crucial. A significant premium might indicate strong demand for the ETF, while a persistent discount could suggest weak demand or liquidity issues. Investors also interpret exchange traded fund shares based on their underlying index or investment objective, allowing them to gain exposure to specific market segments, asset classes, or investment strategies, whether through passive investing or active management.

Hypothetical Example

Imagine an investor, Sarah, wants to gain exposure to the technology sector but doesn't want to research and buy individual tech stocks. She decides to invest in an exchange traded fund that tracks a broad technology index. Let's say the "Tech Innovators ETF" (TIE) has exchange traded fund shares trading on the NYSE.

On a given morning, the NAV of TIE is calculated at $100 per share, based on the closing prices of all the underlying tech stocks it holds. However, due to strong investor demand throughout the day, the market price of TIE's exchange traded fund shares rises to $100.05. Sarah places an order to buy 100 shares at this market price. Her total investment is $10,005 (100 shares * $100.05/share), plus any trading commissions.

Later that afternoon, if the underlying tech stocks experience a slight dip, and demand for TIE shares decreases, the market price might fall to $99.98, even if the NAV hasn't changed much. This reflects the real-time trading nature of exchange traded fund shares. If Sarah later decides to sell her shares, she would do so at the prevailing market price at the time of her sale, which could be above or below the NAV, depending on current market conditions and liquidity.

Practical Applications

Exchange traded fund shares are widely used across various aspects of finance and investing:

• Portfolio Diversification: They enable investors to achieve broad market exposure or target specific sectors and asset classes with a single trade, providing instant diversification and reducing idiosyncratic risk.
• Tactical Asset Allocation: Portfolio managers use exchange traded fund shares for quick adjustments to their asset allocation strategies, moving capital efficiently between different market segments in response to economic outlooks or market trends.
• Cost-Effective Investing: Many exchange traded fund shares have relatively low expense ratios compared to actively managed funds, making them an economical choice for long-term investing.
• Short Selling and Hedging: The tradability of exchange traded fund shares allows investors to short sell them, betting on a decline in the underlying index, or to use them for hedging existing positions against market downturns.
• Liquidity Management: For institutional investors, the high liquidity of widely traded exchange traded fund shares can facilitate efficient capital deployment and withdrawal. However, the Federal Reserve has noted that while ETFs are often considered less susceptible to redemption risks than open-end mutual funds due to in-kind redemptions, their role in broader financial system liquidity, especially through authorized participants, warrants attention.⁵

Limitations and Criticisms

While exchange traded fund shares offer numerous advantages, they are not without limitations and criticisms:

• Tracking Error: ETFs aim to replicate the performance of an underlying index, but they may not always do so perfectly. The deviation between an ETF's performance and its benchmark is known as tracking error. This can occur due to various factors, including the costs of managing the fund, the frequency of rebalancing the underlying index, dividend policies, and the efficiency of the replication strategy.⁴ Research indicates that tracking errors are different from zero and can vary based on factors like fund size and expense ratios.³
• Liquidity Mismatches: Although exchange traded fund shares are known for their liquidity on secondary markets, the liquidity of the ETF itself ultimately depends on the liquidity of its underlying assets. In stressed market conditions, if the underlying assets become illiquid, the ETF's share price may deviate significantly from its NAV, creating a "liquidity mismatch."² This can lead to unexpected discounts for investors selling their holdings, potentially amplifying market shocks.¹
• Complex Structures: Some specialized ETFs employ complex strategies, such as using derivatives or leverage, which can introduce additional risks that may not be immediately apparent to all investors.
• Trading Costs: While ETF expense ratios are often low, frequent trading of exchange traded fund shares can incur brokerage commissions, which might erode returns for active traders.

Exchange Traded Fund Shares vs. Mutual Fund Shares

The primary distinction between exchange traded fund shares and mutual fund shares lies in their trading mechanism and pricing.

While both offer diversified exposure to a basket of assets, the ability to trade exchange traded fund shares in real-time offers flexibility that mutual fund shares do not. This makes exchange traded fund shares particularly appealing for active traders or those who wish to make intra-day tactical adjustments to their portfolios. Conversely, the end-of-day pricing of mutual fund shares might be preferred by long-term investors less concerned with intra-day market fluctuations.

FAQs

What is the primary benefit of trading exchange traded fund shares?

The primary benefit is the ability to trade them throughout the day at market prices, similar to individual stocks. This offers greater flexibility and liquidity compared to mutual funds, which are priced only once a day.

Do exchange traded fund shares always trade at their net asset value (NAV)?

No, while they generally trade close to their net asset value (NAV), the market price of exchange traded fund shares can deviate slightly, trading at a premium or discount due to supply and demand dynamics in the market. Market makers help keep this deviation minimal through arbitrage.

Are exchange traded fund shares suitable for long-term investing?

Yes, exchange traded fund shares are highly suitable for long-term investing, especially those tracking broad market index funds. Their low expense ratios and diversification benefits make them a cost-effective way to build a long-term portfolio.

How are exchange traded fund shares regulated?

Exchange traded fund shares and the funds they represent are primarily regulated by the U.S. Securities and Exchange Commission (SEC). The SEC oversees their registration, disclosure requirements, and trading practices, largely under the Investment Company Act of 1940 and the Securities Exchange Act of 1934. In 2019, the SEC adopted Rule 6c-11, often called the "ETF Rule," which streamlined the regulatory process for many ETFs.