ETFs – A Guide to Exchange-Traded-Funds

An infographic that explains what ETFs are, , the different types, the difference with mutuals funds and index funds, and its disadvantages.

An analysis of major financial market crashes has consistently pointed to a lack of liquidity as one of the critical factors. This led to the birth of exchange-traded funds in 1993 as an investment vehicle that combines the flexibility of stocks with the diversity of mutual funds.

Since their inception, ETFs have gained immense popularity among individual and institutional investors alike. They are often considered a better option than mutual funds, offering diversification, arbitrage, and trading opportunities for investors at highly reduced costs.

What Are ETFs?

At a rudimentary level, exchange-traded funds are securities that combine the flexibility of stocks with the diversification of mutual funds. It is an investment fund that comprises assets like bonds, stocks or commodities, and is meant to track a particular index. For example, stock ETFs track indexes such as the Dow Jones Industrial Index, the S&P 500 index, and the Nasdaq. The price of exchange-traded funds varies throughout the trading day, and like stocks, they are traded daily on normal stock exchanges such as the New York Stock Exchange.

The diversification of funds that an ETF provides, much like mutual funds, is one of its most attractive characteristics. In addition, thanks to the available range of options, investors can choose between asset classes like stocks, bonds, and commodities, to name a few, and between different asset types such as small-cap, large-cap, crude oil, technology, and healthcare.

This amalgamation of flexibility and diversity makes exchange-traded funds very popular investment products. However, it is essential to understand that exchange-traded funds are not immune to market volatility just because they contain more than one underlying asset. The volatility will depend on the type of fund and its underlying assets. For example, a European equities ETF with many different securities can become very volatile when there is economic and political turmoil in Europe. Some of the biggest ETFs are SPY SPDR S&P 500, IVV IShares CORE S&P 500, and Vanguard Total Stock Market.

Types of Exchange Traded Funds

There are many different types of exchange-traded funds available in the market today that can generate income and balance out risks in an investor’s financial portfolio. As there are so many to choose from, deciding which one to invest in might be difficult for an investor. Identifying the pros and cons of each type can help investors navigate the risks and rewards and decide which one of these types makes the most sense for their investment strategies and financial goals.

Here is a list of some popular ones:

Bond ETFs: Funds that invest in a portfolio of bonds with different particular strategies, such as U.S. Treasuries or corporate bonds or portfolios with short or long lock-in periods. Bond exchange-traded funds pay out interest every month, while any capital gains are paid annually in the form of dividends.

United States market index ETFs: These funds track major U.S. stock indexes and are some of the most popular funds. They are designed to match the returns from the underlying index.

Industry and Sector ETFs: These funds focus on specific industries or sectors such as the oil and gas sector, banking, telecom, high-tech, or healthcare

Commodity ETFs: Funds that trade in commodities like gold or crude oil.

Inverse ETFs: Funds to earn benefits from declines in stock value by shorting them. This means these funds sell stocks when their value is high and hopes to repurchase them at lower prices.

International ETFs: Their focus can be global, regional, or country-specific, and their investments are explicitly in international stock and other foreign-based securities.

Differences Between ETFs and Mutual Funds

Mutual funds and ETFs hold a basket of securities and offer investors a balanced and diversified portfolio to minimize risks. Both are good investment options, but dependent on the investment objective of the individual investor, one might be better than the other. 

  1. Unlike mutual funds, exchange-traded funds can be traded intraday, meaning during normal business hours at market prices, at normal securities exchanges. Mutual funds, on the other hand, can only be directly purchased from the fund at a single Net Asset Value at the end of the day at market closing time.
  2. Most mutual funds have a lock-in period. This is a minimum holding period. Exchange-traded funds can be sold anytime when the exchange is open for business.
  3. ETFs have higher liquidity than mutual funds, are traded on a public exchange, and can usually easily be transferred, bought, or sold among investors. Its liquidity does depend on the type of fund and its underlying assets. 
  4. The different kinds of exchange-traded funds like inverse ETFs and currency ETFs allow for short selling of funds and cushion investors against risks and market crashes. Mutual funds are more long term investments and often do not use these strategies.
  5. ETFs are generally cheaper to own than mutual funds and this is reflected in the expense ratio of a fund. The expense ratio is the amount that an investment company charges investors for the management of the fund and includes all operating costs and management fees. The main reason why mutual funds have a higher expense ratio is that mutual funds are actively managed by qualified mutual fund managers because the assets in them need to be constantly watched and bought or sold to maximize the profits of the fund. Exchange-traded funds are passively managed and follow an index thus reducing the cost of the management fees significantly. 
  6. As Mutual funds are actively managed by experienced fund managers, their goal is to beat the market and help investors profit. Exchange-traded funds are passively managed and track a specific market index.
  7. Exchange-traded funds are more transparent than mutual funds because they are required to declare their holdings at the end of every trading day.
  8. ETFs are more tax-efficient than mutual funds because they are traded like stocks and therefore capital gains on the earnings are assessed only when the shares are bought or sold. This is unlike mutual funds for which capital gains are assessed on the entire fund every time securities within the fund are bought or sold.
  9. Exchange-traded funds have no minimum investment amounts, unlike most mutual funds where investors have to put in a certain minimum amount of money which can be a few thousand dollars. This amount is always higher than the net asset value (NAV) of one unit of the fund. 

Differences Between ETFs and Index Funds

Exchange-traded funds bear more resemblance to index funds than mutual funds but still possess some distinct differences, which are as follows —

  1. ETFs can be designed to follow almost any sector or asset class thus making them an extremely versatile investment tool. Index funds have restrictions when it comes to investment areas.
  2. The different kinds of exchange-traded funds like inverse ETFs and currency ETFs allow for short selling of funds and cushion investors against risks and market crashes. Most index funds do not offer this flexibility
  3. ETFs accumulate the dividends they earn and distribute them to investors at regular intervals, as compared to index funds that reinvest the dividends immediately
  4. Rebalancing the portfolio of an exchange-traded fund might involve the payment of multiple commissions, unlike index funds whose rebalancing attracts no or very low extra charges. 

Disadvantages of ETFs

Like all financial investments, exchange-traded funds have their share of downsides. So before deciding to invest in them, do the research, and take note of some of the disadvantages:

Because exchange-traded funds are traded like stocks, a commission sometimes needs to be paid to buy and sell them. However, these days, many traders can trade them online for free. If a commission is charged, it is usually a flat fee. This is a disadvantage when making frequent small trades as the percentage cost per trade will be larger for smaller trades and smaller for larger trades. 

Another disadvantage is that funds that focus on specific industries limit diversification options, and therefore are riskier than funds that contain securities in different industries.

Also, be aware that some types of exchange-traded funds are more actively handled by designated portfolio managers, resulting in higher operating expenses than their passively-managed counterparts. 

Finally, due to the rising popularity of this investment vehicle, many new funds are frequently created. But, unfortunately, sometimes investors find out after investing in them that there is no real market for them, thus resulting in low trading volumes.

Creation and Redemption of Exchange-Traded Funds

It is clear that exchange-traded funds are unique investment products with many advantages, but how are ETFs actually created, and who creates them? Another question arises: how do they change their supply and keep their prices in check as demand rises and falls? 

Shares of exchange-traded funds are managed through a system known as creation and redemption. First, a prospective fund manager, also known as a Sponsor, gets approval from the Securities and Exchange Commission (SEC) to start the ETF fund. The sponsor then enters an agreement with an Authorized Participant (AP), which is usually an investment bank with the legal right to create/redeem shares of an ETF. Next, the ETF providers work closely with the Authorized Participants to “create a market” for the exchange-traded fund. The AP’s role is to be the gatekeeper, as they decide how many exchange-traded fund shares get created and how many get sold.

Then the Authorized Participant will purchase all the shares of stocks from the index it will be tracking, weighted the same as the index itself, and trades them with the sponsor (ETF fund). The AP, in return, will receive a block of equally valued shares (a creation unit) from the ETF fund. The price of the ETF shares is based on their net asset value (NAV), not the market value at which the ETF happens to be trading. Creation unit blocks typically range in size from 25,000 to 600,000 shares, with the most common size being 50,000 shares. As securities are traded and not sold between the AP and the fund, no taxes have to be paid.

APs can then sell those ETF shares to the public on the open market for a profit. Most large exchange-traded funds use several APs. The number of APs usually depends on the type of fund in question. 

This whole process is known as creation and keeps ETF share prices trading in line with the fund’s underlying Net Asset Value. Exchange-traded funds trade like stocks, and their prices will fluctuate. When the demand goes up, their price goes up, and when the demand goes down, their price will go down. So it is the APs job to keep the ETF share price as close as possible to the value of its underlying assets. 

A graphic that shows the process of creation and redemption of ETF shares between the authorized participant and the Exchange Traded Fund.

For example, let us say that the demand for a particular ETF is suddenly very high and considered an overpriced ETF. The AP will then take action, buy the underlying stocks, trade them with the fund for ETF shares, and then sell ETF shares on the open market. As the supply of ETF shares goes up, it will drive the ETF share price down, resulting in a price that is closer to its fair value.

Thus the AP ensures that there are always enough ETFs for sale and that they never really have to trade at high premiums.

In a reverse mechanism, when the price of an ETF share has gone down due to low demand, the AP purchases ETF shares on the open market, which they then trade with the ETF fund for an equal amount of underlying securities. The AP then goes back to the open market to sell these securities for a profit. Due to the increased demand for the ETFs, the ETF price will go up and get closer to its fair value again.

Conclusion: Are ETFs a Good Investment?

Like all investment vehicles, exchange-traded funds, too, have their pros and cons. For one, they are subject to market risks, and whether or not they are a prudent investment option is highly dependent on an individual’s financial goals. Nevertheless, they are a popular money-making tool in developed markets and are slowly making their presence felt in emerging markets.

ETFs are a good investment option for those who want to make the best of the stock market but lack expertise. Indirect investments handled through exchange-traded funds are good for such individuals because ETFs offer careful fund selections and minimize risks. Also, the absence of a minimum investment amount, low-cost or no commissions, and the flexibility to trade fractions of shares make exchange-traded funds a lucrative option for young investors with low capital.

Exchange-traded funds combine the best of mutual funds and index funds to emerge as a robust investment vehicle. But like all financial tools, they are subject to market conditions and volatility. It is also important to realize that not all ETFs are created equal, and research is necessary to ensure that the ETF selected meets investment goals.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.