Investment type

What Is an Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is a type of investment fund that holds a collection of assets, such as stocks, bonds, or commodities, and trades on stock exchanges like individual stocks. ETFs are classified under the broader financial category of portfolio theory, offering investors a way to gain diversified exposure to various markets or segments. Like mutual funds, ETFs pool money from many investors to invest in a portfolio of securities. Each share of an ETF represents a fractional ownership in this diversified portfolio.

History and Origin

The concept of exchange-traded funds emerged from a need for a more flexible and liquid investment vehicle than traditional mutual funds. The first ETF in the United States, the SPDR S&P 500 ETF Trust (ticker: SPY), was launched on January 22, 1993, by State Street Global Advisors. This groundbreaking product, designed by Nathan Most and Steven Bloom of the American Stock Exchange (AMEX), allowed investors to buy and sell a basket of securities representing the S&P 500 index throughout the trading day.²³ Its introduction provided a new avenue for investors to gain broad market exposure, a capability previously more challenging for retail investors.²² The creation of SPY was, in part, a response to the market volatility experienced during events like "Black Monday" in 1987, as regulators and market participants sought mechanisms to provide securitized and cost-effective exposure to broad market indexes.²¹

Key Takeaways

• An ETF is a basket of securities that trades on a stock exchange like an individual stock, offering intraday liquidity.
• ETFs typically track an underlying index, such as the S&P 500, but can also be actively managed.²⁰
• Investors can gain diversified exposure to various asset classes, sectors, or regions through a single ETF.¹⁹
• ETFs often have lower expense ratios and can be more tax-efficient than traditional mutual funds due to their creation and redemption mechanisms.¹⁸

Formula and Calculation

While there isn't a single "formula" for an ETF in the same way there is for a financial ratio, the value of an ETF's shares is primarily driven by the collective value of its underlying holdings. The most important calculation related to an ETF is its Net Asset Value (NAV). The NAV represents the per-share value of the fund's assets minus its liabilities.

[ NAV = \frac{\text{Total Market Value of Assets} - \text{Total Liabilities}}{\text{Number of Shares Outstanding}} ]

Where:

• Total Market Value of Assets is the current market price of all the securities and cash held by the ETF.
• Total Liabilities includes any expenses or obligations the fund owes.
• Number of Shares Outstanding refers to the total number of ETF shares currently issued.

Unlike mutual funds, which are priced only once a day after the market closes based on their NAV, ETF shares trade on exchanges throughout the day at market prices that may deviate from their NAV. This difference between the market price and the NAV is often referred to as the premium or discount.¹⁷

Interpreting the Exchange-Traded Fund (ETF)

Interpreting an ETF involves understanding its investment objective, underlying holdings, and how its market price relates to its Net Asset Value (NAV). Most ETFs are designed to track a specific index, providing investors with passive investing exposure to that market segment. An ETF's performance should generally align with the performance of its target index, accounting for the ETF's expense ratio and tracking error.

For example, an ETF designed to track the S&P 500 index aims to replicate the returns of the 500 large-cap U.S. companies that compose the index.¹⁶ Investors should also consider the ETF's liquidity, which refers to how easily shares can be bought and sold without significantly impacting the price. Highly liquid ETFs typically have narrow bid-ask spreads, reducing trading costs for investors.

Hypothetical Example

Consider an investor, Sarah, who wants diversified exposure to the technology sector but doesn't want to research and buy individual tech stocks. She decides to invest in a hypothetical "Tech Innovators ETF" (TIE).

1. Investment Objective: The TIE aims to track a custom index of 100 leading technology companies.
2. Purchase: On a Monday morning, Sarah places an order to buy 100 shares of TIE at its current market price of $50 per share through her brokerage account. The total cost is $5,000, plus a small commission if applicable.
3. Intraday Trading: Throughout the day, the price of TIE fluctuates with the market's perception of the underlying tech stocks. If technology stocks rally, TIE's price might rise to $51 per share. If they fall, the price might drop to $49.
4. Portfolio Diversification: By owning shares of TIE, Sarah instantly gains exposure to all 100 technology companies in the index without having to purchase each stock individually. This diversification reduces her single-stock risk.
5. Future Actions: A few months later, if the tech sector has performed well and Sarah's investment has appreciated, she can sell her TIE shares on the exchange at the prevailing market price.

Practical Applications

Exchange-traded funds have a wide range of practical applications in investing and financial planning:

• Diversification: ETFs provide a simple way to achieve broad market diversification across various asset classes, industries, or geographic regions with a single trade.¹⁵
• Core Portfolio Holdings: Many investors use broad-market ETFs, such as those tracking the S&P 500 or total bond markets, as core holdings within their investment portfolios.
• Sector and Industry Exposure: Investors can target specific sectors (e.g., healthcare, energy) or industries (e.g., cybersecurity, clean energy) by investing in specialized ETFs.
• International Investing: ETFs offer a convenient way to gain exposure to foreign markets without directly investing in individual foreign stocks.
• Tactical Asset Allocation: Portfolio managers use ETFs to quickly adjust their asset allocation strategies in response to market changes or economic outlooks.
• Cost-Efficiency: Generally, ETFs have lower operating expenses compared to actively managed mutual funds, making them a cost-effective investment option.¹⁴
• Trading Flexibility: Since ETFs trade on exchanges like stocks, they offer intraday trading flexibility, allowing investors to buy or sell shares at any time during market hours. This contrasts with mutual funds, which typically execute trades only once a day after market close based on their net asset value.

Limitations and Criticisms

Despite their popularity, ETFs have certain limitations and criticisms:

• Tracking Error: While ETFs aim to track an index, slight deviations can occur due to factors like management fees, trading costs, and the liquidity of underlying assets. This is known as tracking error.
• Liquidity Risk: Although ETFs are generally considered liquid, some less popular or highly specialized ETFs may have lower trading volumes, leading to wider bid-ask spreads and potentially higher transaction costs for investors.¹³ Additionally, the liquidity of an ETF can be an "illusion" if its underlying assets are illiquid, posing a risk during market stress.¹² The Federal Reserve Bank of Chicago has highlighted that liquidity risks can intensify across financial markets during periods of economic uncertainty.¹¹
• Premiums and Discounts: While arbitrage mechanisms typically keep an ETF's market price close to its NAV, during periods of extreme market volatility or for less liquid ETFs, significant premiums or discounts can occur, meaning investors might buy or sell shares at a price above or below the true value of the underlying assets.¹⁰
• Complexity of Niche ETFs: The proliferation of highly specialized or leveraged ETFs can introduce significant risks and complexity, particularly for retail investors who may not fully understand the intricate strategies or potential for magnified losses.⁹
• Over-diversification: While diversification is a benefit, it is possible to become over-diversified by holding too many different ETFs, which can lead to diluted returns and make portfolio management more complex.⁸

Exchange-Traded Fund (ETF) vs. Mutual Fund

Exchange-traded funds (ETFs) and mutual funds are both pooled investment vehicles that offer diversification, but they differ significantly in their trading characteristics and operational structures. The primary distinction lies in how they are bought and sold. ETFs trade on stock exchanges throughout the day, similar to individual stocks, meaning their price can fluctuate constantly based on supply and demand. In contrast, mutual funds are priced only once per day, after the market closes, at their Net Asset Value (NAV).

This intraday trading capability of ETFs provides greater flexibility for investors who wish to enter or exit positions at specific price points.⁷ However, this also means ETF prices can deviate slightly from their NAV, trading at a premium or discount, whereas mutual fund transactions always occur at NAV.⁶ From a cost perspective, ETFs generally boast lower expense ratios than actively managed mutual funds, a feature that can lead to greater tax efficiency for investors.⁵ While both offer diversification, mutual funds often facilitate automatic investments more easily, making them suitable for long-term, set-and-forget strategies.⁴

FAQs

What is the primary difference between an ETF and a stock?

The primary difference is that an ETF is a basket of multiple securities, such as stocks or bonds, providing immediate diversification. A single stock represents ownership in just one company. When you buy an ETF, you gain exposure to many underlying assets with one investment.

Can you lose money investing in an ETF?

Yes, like any investment, ETFs carry risk, and you can lose money. The value of an ETF's shares can decrease if the value of its underlying holdings declines due to market downturns, economic events, or poor performance of the assets it tracks.³

Are ETFs suitable for beginners?

Many ETFs, especially broad-market or index-tracking ETFs, are considered suitable for beginners. They offer diversification, professional management, and often lower costs, making them a straightforward way to start investing in a diversified portfolio. However, complex or highly specialized ETFs may be less appropriate for novice investors.²

Do ETFs pay dividends?

Many ETFs that hold dividend-paying stocks or bonds will distribute those dividends or interest payments to their shareholders. Investors often have the option to receive these as cash or to have them automatically reinvested to purchase more shares of the ETF.¹

How do I buy an ETF?

To buy an ETF, you need a brokerage account with an investment firm. Once your account is funded, you can search for the desired ETF by its ticker symbol and place a buy order, similar to how you would purchase an individual stock.