Updated: May 26, 2018
What ETFs are
Exchange-traded funds (ETFs) are basically investment funds traded on stock exchanges, just like common stocks. Investors must buy ETF shares through a brokerage and not directly from a fund company. They bundle up investors’ money to purchase a diversified portfolio of stocks or bonds. Most ETFs are index funds, which means that they passively imitate the performance of their corresponding index instead of exceeding them. It also means that ETFs don’t need managers to choose which investments to hold or lose.
How ETFs work
Distributors can only buy or sell ETFs straight from or to authorized broker-dealers. ETFs are then exchanged with bundles of the securities in creation units, which are large numbers of thousands to millions of ETF shares. Approved participants can invest in ETF shares for the long term, but they mostly stand as market markers on the open market. In other words, ETFs’ capability to exchange creation units to provide high liquidity guarantee that their constantly changing market price come close to the net asset value (NAV) of the underlying assets.
The valuation system for ETFs
ETFs are valued based on the values of a mutual fund or unit investment trust. They both can be bought or sold at the end of trading day for its net asset value. They also have a feature called close-end fund, which means the price of the shares can be higher or lower than its net asset value. It is easy to get close-end funds and ETFs mixed up, since they are both funds traded on a stock exchange. They are still different though, despite having the same valuation system.
The flexibility of ETFs
ETFs and mutual funds are very much alike. Thus, even new investors will have little to no difficulty in understanding how they work. ETFs integrate the range of diversified portfolios with the ease of trading a stock. Investors can buy ETF shares on margin, short sell the shares, or hold them for the long term. ETFs have higher liquidity than mutual funds throughout the day. It means that they are not priced only after market closings like mutual funds. ETFs constantly encounter price ups and downs as they are bought and sold. Investors can invest as much or as little money as they want, since there is no minimum investment requirement. Investors can also get into and out of their investment situation with minimum risk and payment.
The cost of ETFs
ETFs can be an attractive alternative for investors because they have lower fees than shares in mutual funds. ETFs require fewer administrative expenses (less than 0,2% annually) than actively managed portfolios (over 1% annually) in the same index. ETFs cost less because they imitate an index without trying to surpass it. They usually don’t have high sales loads so there are fewer persisting costs to decrease investors’ returns. ETFs are also less actively managed than mutual funds. Fewer trading activities mean fewer taxable distributions, making it more tax-efficient.