What Is Exchange Traded Fund?

Definition

Exchange Traded Fund (ETF) is a type of investment fund that is traded on a stock exchange, like individual stocks, and holds a basket of assets, such as stocks, bonds, or commodities, allowing investors to buy and sell a representative portion of the overall fund, with the first ETF created by Nathan Most and Steven Bloom in 1993.

How It Works

ETFs are designed to track a specific index, sector, or asset class, such as the S&P 500 or gold, and are traded throughout the day, allowing investors to quickly react to market changes. The arbitrage mechanism ensures that the ETF's price remains close to its net asset value (NAV), as any significant deviation would create an opportunity for arbitrageurs to profit by buying or selling the ETF and the underlying assets. For example, Vanguard's Total Stock Market ETF tracks the CRSP US Total Market Index, which covers nearly 100% of the investable US stock market, with over $1 trillion in assets under management (Vanguard annual report).

The creation and redemption process is a critical component of ETFs, as it allows authorized participants to exchange a basket of assets for ETF shares, or vice versa, helping to maintain the ETF's price in line with its NAV. This process is facilitated by the in-kind creation and redemption mechanism, which enables authorized participants to deliver a basket of securities to the ETF in exchange for ETF shares, rather than cash. According to BlackRock, the iShares Core S&P 500 ETF has a creation unit size of 50,000 shares, with a trading volume of over 10 million shares per day (BlackRock prospectus).

The tax efficiency of ETFs is another key benefit, as they are generally more tax-efficient than mutual funds due to their pass-through tax structure, which allows the ETF to pass through the tax liabilities of the underlying assets to the investors, rather than being taxed at the fund level. This is particularly important for investors in high-tax brackets, as it can help to minimize tax liabilities and maximize after-tax returns. For example, the iShares Core US Aggregate Bond ETF has a tax cost ratio of 0.03%, compared to 0.12% for a similar mutual fund (Morningstar).

Key Components

• Underlying assets: The securities, commodities, or other assets held by the ETF, which determine its investment objective and risk profile. An increase in the value of the underlying assets will generally increase the ETF's NAV.
• Index or benchmark: The reference index or benchmark that the ETF is designed to track, such as the S&P 500 or the Barclays Capital US Aggregate Bond Index. A change in the index or benchmark can affect the ETF's investment strategy and portfolio composition.
• Authorized participants: The institutions, such as market makers or specialists, that are authorized to create and redeem ETF shares, and help to maintain the ETF's price in line with its NAV. An increase in the number of authorized participants can improve the ETF's liquidity and trading efficiency.
• NAV: The net asset value of the ETF, which represents the total value of the underlying assets minus liabilities, divided by the number of outstanding shares. A decrease in the NAV can indicate a decline in the value of the underlying assets.
• Trading volume: The number of ETF shares traded during a given period, which can affect the ETF's liquidity and price volatility. A high trading volume can indicate strong investor interest and demand for the ETF.
• Expense ratio: The annual fee charged by the ETF provider to manage the fund, which can range from 0.03% to over 1.00% depending on the ETF and its investment objective. A decrease in the expense ratio can increase the ETF's net returns to investors.

Common Misconceptions

Myth: ETFs are only for experienced investors — Fact: ETFs can be used by investors of all levels, from beginners to institutional investors, as they offer a diversified portfolio and professional management (Investment Company Institute).

Myth: ETFs are always more expensive than mutual funds — Fact: Many ETFs have lower expense ratios than comparable mutual funds, with the average ETF expense ratio being 0.44% compared to 0.63% for mutual funds (Morningstar).

Myth: ETFs are only for US investors — Fact: ETFs are available in many countries, including Canada, the UK, and Australia, and can be used by investors globally to access a wide range of markets and asset classes (BlackRock).

In Practice

The iShares Core S&P 500 ETF is one of the largest and most widely traded ETFs, with over $250 billion in assets under management and a trading volume of over 10 million shares per day (BlackRock). The ETF tracks the S&P 500 Index, which covers the 500 largest publicly traded companies in the US, and has a dividend yield of 1.95% and a price-to-earnings ratio of 22.1 (S&P Dow Jones Indices). The ETF's expense ratio is 0.04%, making it one of the lowest-cost options for investors seeking to track the US stock market (iShares).