Exchange traded funds: Meaning, Criticisms & Real-World Uses

What Are Exchange Traded Funds?

Exchange traded funds (ETFs) are a type of investment vehicle that holds a collection of assets, such as stocks, bonds, or commodities, and trades like individual stocks on a stock exchange. Falling under the broader financial category of Investment Vehicles, ETFs offer investors a way to gain exposure to a diversified portfolio of assets without directly purchasing individual securities. They combine characteristics of both traditional mutual funds and individual stocks, providing a flexible and often cost-effective investment option. Unlike mutual funds, which are priced once at the end of each trading day, ETFs can be bought and sold throughout the day at market prices, similar to common shares.

History and Origin

The concept of exchange traded funds emerged in the late 1980s, driven by a desire for more flexible and liquid investment products following market events such as the 1987 Black Monday crash. Regulators and financial institutions sought a security that could represent a broad market index, akin to futures contracts, to potentially mitigate market volatility. This led to the development of the first U.S.-listed ETF, the SPDR S&P 500 ETF Trust (SPY), which launched on January 22, 1993. This groundbreaking fund, designed to track the performance of the S&P 500 Index, was a collaboration between State Street Global Advisors and the American Stock Exchange. Its introduction marked a significant shift in the investing landscape, making it easier for individual investors to access broad market exposure⁴, ⁵. Since its inception, the exchange traded funds industry has expanded dramatically, offering investors a wide range of targeted exposures and investment strategies³. The initial registration statements for the SPDR S&P 500 ETF Trust provide insight into its foundational structure and regulatory considerations at the time of its launch.²

Key Takeaways

Exchange traded funds (ETFs) are baskets of securities that trade on stock exchanges like individual stocks.
They offer diversification and can track various indexes, sectors, or asset classes.
ETFs typically have lower expense ratios compared to actively managed mutual funds due to their often passive investing strategies.
Their intraday trading capability provides greater liquidity for investors.
ETFs can be used for various investment goals, from long-term portfolio building to tactical trading.

Formula and Calculation

While there isn't a single "formula" for an ETF's value, its market price generally fluctuates around its net asset value (NAV). The net asset value (NAV) of an exchange traded fund is calculated at the end of each trading day and represents the per-share value of the fund's underlying assets minus its liabilities.

The NAV per share is calculated as follows:

NAV \text{ per Share} = \frac{\text{Total Value of Assets} - \text{Total Liabilities}}{\text{Total Number of Shares Outstanding}}

Total Value of Assets: The sum of the market value of all securities, cash, and other holdings within the ETF's portfolio.
Total Liabilities: Any outstanding debts or expenses owed by the fund.
Total Number of Shares Outstanding: The total number of ETF shares currently held by investors.

During the trading day, the market price of an ETF can deviate slightly from its NAV due to supply and demand dynamics. However, large institutional investors and market makers engage in an arbitrage mechanism that helps keep the market price closely aligned with the NAV.

Interpreting Exchange Traded Funds

Interpreting exchange traded funds involves understanding both their market price and their underlying composition. Since ETFs trade on exchanges, their price reflects real-time supply and demand, similar to individual stocks. However, it is crucial to consider the fund's net asset value (NAV) to assess if the ETF is trading at a premium (market price above NAV) or a discount (market price below NAV). While small premiums or discounts are common, significant deviations can occur, particularly in less liquid ETFs or during periods of market stress.

Beyond pricing, understanding the ETF's investment objective and the indexes or assets it tracks is paramount. An investor should examine the fund's holdings to ensure it aligns with their investment strategy and provides the desired exposure, whether it's to a broad market index, a specific sector, or a particular asset class like bonds or commodities.

Hypothetical Example

Consider an investor, Sarah, who wants exposure to the broad U.S. technology sector without buying individual technology stocks. Instead of researching and purchasing shares in numerous tech companies, she decides to invest in a hypothetical "Tech Innovators ETF."

Initial Investment: Sarah logs into her brokerage account and searches for technology-focused exchange traded funds. She finds the Tech Innovators ETF, which tracks an index of the 100 largest U.S. technology companies.
Purchase: The current market price of the Tech Innovators ETF is $150 per share. Sarah decides to buy 10 shares, making her total investment $1,500 (plus any brokerage fees).
During the Day: Throughout the trading day, the price of the ETF fluctuates with the performance of the underlying tech stocks and market sentiment. If the tech sector has a strong day, the ETF's market price might rise to $152 per share. If the sector declines, it might drop to $148.
End of Day: At market close, the ETF's administrator calculates its official net asset value. Let's say the NAV is $151. If the ETF closed at $152, it was trading at a small premium.
Distributions: Over time, the companies held within the Tech Innovators ETF might pay dividends. These are collected by the ETF and typically passed on to Sarah, the shareholder, as dividend distributions. If any of the underlying stocks are sold for a profit by the ETF, this might result in capital gains distributions.

Through this single investment in the Tech Innovators ETF, Sarah gains diversified exposure to the technology sector, benefiting from the collective performance of many companies without managing them individually.

Practical Applications

Exchange traded funds are widely used across various aspects of investing, markets, and financial planning due to their flexibility and efficiency.

Diversification and Portfolio Building: ETFs allow investors to achieve broad market exposure to stocks, bonds, commodities, and other asset classes with a single security, making them foundational tools for building diversified portfolios.
Sector and Industry Specific Exposure: Investors can target specific sectors (e.g., technology, healthcare) or industries (e.g., renewable energy) using specialized ETFs, enabling focused investment strategies.
Geographic Allocation: ETFs provide access to international markets and specific countries, simplifying global diversification for investors.
Passive Investing Strategies: Many exchange traded funds are designed to track specific indexes, facilitating passive, low-cost investment approaches. This approach gained significant traction and continues to reshape the asset management industry¹.
Tactical Trading and Hedging: The ability to trade ETFs throughout the day makes them useful for tactical allocation shifts or for hedging existing portfolio positions against short-term market movements.
Cost Efficiency: With generally lower expense ratios compared to many traditional funds, exchange traded funds can reduce overall investment costs over time.

Limitations and Criticisms

Despite their widespread adoption and benefits, exchange traded funds also have limitations and have faced criticisms. One concern relates to their potential for widening discrepancies between market prices and net asset values (NAV) during periods of high volatility or market stress, particularly for less liquid or niche ETFs. While arbitrage mechanisms generally keep market prices close to NAV, extreme conditions can test these mechanisms, leading to trading at significant premiums or discounts.

Another critique points to the sheer proliferation of highly specialized exchange traded funds, some of which track narrow segments or employ complex strategies. These can be easily misunderstood by individual investors, potentially leading to unintended risks or concentrated exposure rather than true diversification. For example, inverse or leveraged ETFs are designed for short-term trading and can lead to significant losses if held for extended periods due to their daily rebalancing mechanisms. Furthermore, the increasing complexity and variety of some exchange traded funds have led to scrutiny regarding their potential impact on market stability and investor protection [ft.com]. While most ETFs are known for their tax efficiency, particularly in terms of capital gains, certain complex ETF structures may not always deliver the expected tax advantages.

Exchange Traded Funds vs. Mutual Funds

Exchange traded funds (ETFs) and mutual funds are both popular investment vehicles that pool money from multiple investors to buy a diversified portfolio of securities. However, key differences lie in their trading mechanisms, pricing, and cost structures.

Feature	Exchange Traded Funds (ETFs)	Mutual Funds
Trading	Traded on exchanges throughout the day like stocks	Priced once per day after market close
Pricing	Market price fluctuates intraday	Based on end-of-day net asset value (NAV)
Fees	Typically lower expense ratios; may involve brokerage commissions	Can have higher expense ratios, loads (sales charges)
Management	Predominantly passive investing, tracking indexes	Can be actively or passively managed
Tax Efficiency	Generally more tax-efficient due to in-kind creation/redemption mechanisms, potentially fewer capital gains distributions	May generate more frequent capital gains distributions
Liquidity	High intraday liquidity for actively traded ETFs	Redeemable at NAV at end of day

The primary point of confusion often arises because both provide diversification and professional management. However, investors need to consider their trading preferences, cost sensitivity, and tax implications when choosing between exchange traded funds and mutual funds.

FAQs

What is the main benefit of investing in an exchange traded fund?

The main benefit of investing in an exchange traded fund is the ability to gain diversified exposure to a basket of securities—such as stocks or bonds—with a single trade. This offers broad market access and can be more cost-effective than buying individual securities or some traditional mutual funds.

How do exchange traded funds make money for investors?

Exchange traded funds generate returns for investors through two primary ways: capital appreciation and distributions. Capital appreciation occurs when the market price of the ETF shares increases. Distributions come from the underlying assets, such as dividends from stocks or interest from bonds, and are typically paid out to ETF shareholders.

Are exchange traded funds safe investments?

Like all investments, exchange traded funds carry inherent risks, including market risk, which means their value can fluctuate and you could lose money. While ETFs offer diversification and are generally transparent in their holdings, they are not risk-free. It's important to understand the specific risks associated with the ETF's underlying assets and investment strategy.

Can you buy exchange traded funds without a broker?

To buy exchange traded funds, you typically need a brokerage account. ETFs trade on stock exchanges, and a broker facilitates the buying and selling of these shares for investors. Many online brokerages offer easy access to ETF trading, often with low or no commissions.