Exchange traded funds etfs

What Is Exchange Traded Funds ETFs?

An exchange-traded fund (ETF) is an investment fund that holds a collection of securities, such as stocks, bonds, or other assets, and trades like a common stock on a stock exchange. Belonging to the broader category of investment vehicles, ETFs offer investors a way to pool money in a professionally managed portfolio. Each share of an ETF represents proportional ownership in the underlying assets of the fund. Unlike traditional mutual funds, ETFs can be bought and sold throughout the trading day at market price, offering greater flexibility.¹³

History and Origin

The concept of pooled investment vehicles has a long history, but exchange-traded funds ETFs as we know them today emerged in the late 20th century. Their development was closely tied to the evolution of financial regulation and market demand for more flexible investment products. In the United States, ETFs must register with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, which governs pooled investment schemes.¹² The first U.S. ETF, the SPDR S&P 500 ETF (SPY), was introduced in 1993, designed to track the performance of the S&P 500 Index. This innovation allowed investors to gain exposure to a broad market index through a single, easily tradable security. The Investment Company Institute (ICI), an association representing regulated funds, has tracked the growth and regulation of these funds since their inception.¹¹

Key Takeaways

• ETFs are pooled investment vehicles that trade on exchanges like individual stocks, offering intraday liquidity.
• They provide diversification by holding a basket of securities, managed by an investment adviser.¹⁰
• ETFs typically have lower expense ratios compared to actively managed mutual funds, especially index-tracking ETFs.
• The unique creation and redemption mechanism involving Authorized Participants helps keep an ETF's market price aligned with its net asset value (NAV).
• Investors can make money from ETFs through dividend payments and capital appreciation if the underlying assets increase in value.⁹

Formula and Calculation

While there isn't a single "formula" for an ETF itself, its value is derived from the net asset value (NAV) of its underlying holdings. The NAV per share is calculated at the end of each trading day, similar to mutual funds.

The Net Asset Value (NAV) per share is calculated as:

For an ETF, its market price on the exchange can fluctuate throughout the day, and it may trade at a slight premium or discount to its NAV. This difference is typically kept narrow by the arbitrage mechanism involving Authorized Participants.

Interpreting the Exchange Traded Funds ETFs

Interpreting an ETF involves understanding its investment objective and how its market price relates to its underlying value. Because ETFs trade on an exchange, their prices are subject to real-time supply and demand, which can lead to a divergence from the net asset value (NAV) of the underlying investment fund. This difference, known as the premium or discount, is usually small for highly liquid ETFs. A key aspect of understanding ETFs is recognizing that their liquidity is often deeper than their average daily trading volume suggests, as it is also driven by the liquidity of the underlying securities and the creation/redemption process.⁸ Investors should also review an ETF's expense ratio and tracking error, which measures how closely the ETF's performance matches its stated benchmark.

Hypothetical Example

Consider an investor, Sarah, who believes in the long-term growth of renewable energy. Instead of researching and buying individual stocks of solar panel manufacturers, wind turbine companies, and battery storage firms, she decides to invest in a hypothetical "Global Green Energy ETF" (GGE).

1. Initial Investment: Sarah opens a brokerage account and, through her broker, places an order to buy 100 shares of GGE at its current market price of $50 per share. Her total investment is $5,000.
2. Portfolio Exposure: The GGE ETF holds a diversified portfolio of companies across the renewable energy sector worldwide. This provides Sarah with instant diversification that would be difficult and costly to achieve by buying individual stocks.
3. Market Fluctuations: Over several months, as the renewable energy sector grows, the value of the underlying securities within the GGE ETF increases. The ETF's market price rises to $55 per share.
4. Realizing Gains: Sarah decides to sell her shares. She places an order to sell her 100 shares at $55 each, receiving $5,500. After accounting for her initial investment, she has a capital gain of $500, excluding any trading fees or dividends received.

This example illustrates how ETFs offer a convenient and cost-effective way to gain exposure to specific market segments or asset classes.

Practical Applications

Exchange-traded funds ETFs are widely used across various investment strategies due to their versatility and cost-efficiency. They serve as core holdings for long-term investors seeking broad market exposure, such as investing in an ETF that tracks a major stock index.⁷ For tactical asset allocation, investors can use ETFs to quickly shift exposure between different asset classes, sectors, or geographic regions. For instance, an investor might use a bond ETF to gain exposure to the fixed-income market without buying individual bonds.⁶

ETFs are also employed by institutional investors and traders for hedging existing positions or for speculative purposes. Their intraday tradability and often narrow bid-ask spread make them suitable for active trading strategies. As of year-end 2023, the U.S. ETF industry managed $8.1 trillion in total net assets, highlighting their significant role in global financial markets.⁵

Limitations and Criticisms

While exchange-traded funds ETFs offer numerous benefits, they also have limitations and have faced criticisms. One potential concern relates to liquidity, particularly for ETFs holding less liquid underlying assets like certain corporate bonds or emerging market securities. In periods of market stress, the ability of Authorized Participants to perform arbitrage and keep the ETF's market price aligned with its NAV can be challenged, leading to wider premiums or discounts.⁴

Another criticism sometimes leveled at ETFs is their potential to contribute to systemic risk, especially those that employ leverage or inverse strategies, though these are less common. Furthermore, while most ETFs track indexes efficiently, tracking error can occur, meaning the ETF's performance may deviate from its benchmark due to factors like fees, sampling methods, or rebalancing costs. Investors should also be aware that, like any investment, ETFs are not guaranteed and carry inherent risks, including the potential loss of principal.³

Exchange Traded Funds ETFs vs. Mutual Funds

Exchange-traded funds (ETFs) and mutual funds are both popular pooled investment fund types that allow investors to gain diversified exposure to various assets. However, their operational structures and trading mechanisms differ significantly.

The primary distinction lies in how they are traded and priced. ETFs offer the flexibility of real-time trading and often benefit from lower costs and greater tax efficiency, while mutual funds are typically suited for long-term, buy-and-hold investors who do not require intraday trading capabilities.

FAQs

Q: What is the main advantage of investing in ETFs?
A: The main advantage of ETFs is their combination of diversification, low costs, and intraday tradability. They offer broad market exposure and can be bought and sold like individual stocks throughout the trading day.

Q: Are ETFs suitable for all investors?
A: ETFs can be suitable for a wide range of investors, from beginners seeking diversified portfolios to experienced traders. However, it is essential for investors to understand the specific ETF's objective, risks, and fees before investing.¹

Q: Do ETFs pay dividends?
A: Many ETFs that hold dividend-paying stocks or bonds will pass those dividend payments on to their shareholders. The frequency of payments (e.g., monthly, quarterly) depends on the specific ETF.