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What is an ETF?
An Exchange Traded Fund (ETF) is a kind of investment fund. Like a mutual fund, an ETF gives investors an undivided share of a basket of securities (stocks, bonds, money market instruments, etc.). Unlike a mutual fund, ETFs trade on exchanges, just like stocks, and can be bought and sold during the trading day. In contrast, investors can only buy or sell mutual funds at the end of the trading day at the closing price. Additionally, investors can execute option strategies (puts, calls, etc.) and other buying and selling mechanisms with ETFs (such as limits, stops, and margin buying, etc.).
The number and variety of ETFs have increased exponentially in the last ten years. Investors can now buy index ETFs, which are designed to track the performance of particular equity indices, and commodity, bond, or currency ETFs, which give exposure to those underlying asset classes. Other less common types of ETFs are actively managed funds, which may try to outperform benchmarks, and leveraged ETFs, which may try to double the return or short the performance of an index (by using derivative trades).
ETFs are attractive to investors for several reasons. First, they tend to have materially lower expense ratios compared to traditional mutual funds, because they are (usually) not actively managed and do not incur redemption-related expenses like mutual funds (on how this is achieved, see more below). Second, they have certain tax advantages; investors should note that these tax advantages are lost if the fund is purchased as part of a tax-advantaged retirement fund. Third, ETFs can give investors a relatively easy way to gain access to a diverse array of markets that are sometimes difficult for retail investors to buy into, such as country-, commodity-, or industry-specific sectors. Finally, ETFs are more transparent and tradable than traditional mutual funds. The identity and weighting of their component assets are publicly disclosed daily, making them transparent; they can be traded just like stocks and this gives investors many more ways to profit from owning them.
Some Specifics on How ETFs Trade
ETFs have low expense ratios and are tradable because of the way they are created. A fund manager creates the ETF, which is then sold in large blocks to authorized market makers, almost always large financial institutions. These transactions are usually in-kind, that is, the market-maker exchanges the actual underlying securities for the ETF representing the securities. The market makers then turn around and sell the ETFs to retail investors through brokers. This secondary market, which takes place on exchanges, is where investors buy and sell the ETFs. This set-up makes the expense ratios low, because the ETF does not have to buy and sell securities every time an investor decides to buy or sell the ETF, nor does it have to keep a cash reserve for honoring immediate redemptions. It also keeps the capital gains taxes low.
But ETF investors should be aware that this also means that the ETF does not necessarily trade at the Net Asset Value (NAV) of the underlying securities in the fund. Theoretically, ETFs trade at a negligible divergence from the NAV of the fund’s underlying securities. This is because of the market makers’ ability to buy and sell the ETFs directly in exchange for the underlying securities, which creates an arbitrage opportunity for the market makers that should serve to close the NAV to ETF price gap, should one ever arise. Statistics show that the divergence of NAV and ETF price is generally less than 2%. However, in November of 2008, a period of convulsive market movements, the divergence in certain ETFs rose to 5% or even 10%.
So investors should be aware of this feature of ETFs and consider the risks before making any investments.