We have all heard the term thrown around, but how many of us truly know what exactly an ETF is? Fault can be placed on an industry in love with its own language and the unique way ETF’s work. We are going to break it down nice and slow for those of us who view ETF’s with an air of mystery.
What are ETF’s?
Firstly, ETF’s just represent a portfolio or basket of securities (investments). This enables investors to hedge risk by spreading it out across more than just a few investments. ETF’s can track indexes, like the S&P 500 (with its ETF derivative being SPDR S&P 500), or specific sectors of the global economy (like commodities, real estate, or currencies). This makes ETF’s very similar to mutual funds–both being highly favored in the passive investment industry, which is worth a mind-boggling $6.2 trillion. A key differentiating factor is that ETF’s can be bought and sold like individual stocks during market hours. They also exclusively trade on electronic exchanges (hence the moniker, Exchange-Traded Funds).
What Gives an ETF its Value?
ETF’s are sold in units and these units fluctuate in price much like a stock. Instead of an individual company’s performance dictating the price, though, the price of an ETF unit is determined by the Net Asset Value of its underlying assets. Stay with me here, as this concept is quite simple. Basically, you tally up all the assets and cash owned by the ETF (think of it as a big umbrella), subtract all outstanding liabilities, and then divide this by the number of units afforded. Bang, you have your unit price.
NAV prices are locked-in at 4pm, when underlying asset prices settle for the day. Because of this latency when settling an ETF’s unit price, this opens the door to arbitrage plays by sophisticated investors. They will simply buy up the underlying stocks of the ETF if the NAV price hovers above a real-time value. By virtue of supply and demand forces, this will set the NAV back to the price of its underlying shares, achieving equilibrium.
How Are ETF’s Created?
That’s the interesting part. ETF’s follow a series of what is called “creations and redemptions.” An institutional finance company (referred to as the “sponsor”) buys an allotment of shares (anywhere from 10,000 to 600,000) and holds them in a trust account. The newly created ETF then issues contractual shares (or units) to investors.
Why Not Just a Mutual Fund?
ETF’s can be actively managed by professionals and have lower expense ratios than mutual funds, on average. For the sponsors or finance companies that offer ETF’s, they avoid a tax liability when ETF units are bought and sold on an exchange as no underlying shares actually change hands. Remember, an ETF unit can be viewed as a contractual obligation. Additionally, because ETF’s are traded on the open market, this means they are more liquid than mutual funds and are a more expedient alternative if a cashflow need arises.