What is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a single security that provides exposure to a basket of underlying securities, like a mutual fund share. Exchange-traded funds can contain all types of investments—such as stocks, commodities, or bonds. ETFs will typically track a certain index, sector, commodity, or other asset class.
How do ETFs Work?
It’s called an exchange-traded fund because it’s traded on an exchange, just like a stock. An ETF’s share price will fluctuate throughout the trading day as the shares are bought and sold in the market.
Creation/Redemption Process
To understand the ETF structure and its many benefits, it’s imperative to understand the creation/redemption process. This process is unique to ETFs. They can expand or contract shares outstanding daily. Creation is the process when new ETF shares are issued to the market, and redemption is the process of retiring existing shares of the ETF. When demand for an ETF is higher than the current supply, a creation order is placed, and new shares are issued into the market to meet demand. The reverse happens with a redemption order when demand is lower than the current supply of shares. This mechanism enhances the liquidity of the ETF and keeps its market price in line with the fund’s net asset value (NAV).
This may sound like the subscription/redemption process for mutual funds, and it is, but with a few key differences. First, the creation/redemption of ETFs may only be facilitated in large blocks of ETF shares (generally 50,000), and only occur between large institutional traders called Authorized Participants (APs) and the fund issuer. Second, the process is facilitated in-kind, meaning that, instead of exchanging cash for shares of the ETF, APs will deliver a basket of underlying securities that represents a pro-rata slice of the fund in exchange for shares of the ETF. This mechanism allows for certain tax benefits that will be discussed later in the article.
What are the Benefits of Exchange-Traded Funds (ETFs)?
Easy to Trade
Exchange-traded funds tend to be traded more easily than other types of funds. They are thought to be more liquid and cost-effective than mutual funds—mutual funds are not traded on an exchange; rather, they are traded once per day after the markets close. ETFs can be purchased intraday directly in an investor’s brokerage account or online trading platform.
More Tax-Efficient
ETFs tend to generate a lower level of capital gain distributions compared to actively managed mutual funds. This is due to the in-kind creation/redemption mechanism discussed above. When selling shares of a stock or a mutual fund at a gain, investors incur capital gains tax on the sale. When an ETF is redeemed in kind (i.e., shares for shares as opposed to shares for cash), no tax liability is created on the transaction.
Diversification
ETFs innately provide risk management by comprising of multiple stocks and avoiding single stock risk.
Themes
Some ETFs allow you to harness themes (i.e. ESG, cannabis, video game tech) in one trade. This allows you to target a whole industry rather than just one stock. You also put your money where your values/interests are on a larger scale.
How do you Invest in ETFs?
How you want to invest in an ETF is completely preferential. We recommend you first consult with a financial advisor. After completing the necessary research, purchase the ETF of your choice through your preferred online trading platform. How long you hold onto the ETF depends on your investment strategy.
What are the Types of ETFs?
Stock ETFs
Contain a basket of stocks to track a particular sector.
Industry/Sector ETFs
Designed to provide exposure to a single industry, such as cannabis, ESG, or shipping.
Commodity ETFs
Tracks the price of a commodity, such as silver and shipping.
Inverse* ETFs
Designed to earn gains from stock declines.
Leveraged* ETFs
Seeks to return a multiple (i.e., 2x, 3x) on the return.
*Investing in a Leveraged or Inverse ETF may be more volatile than investing in broadly diversified funds. The use of leverage by an ETF increases the risk to the ETF and are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking leveraged, or inverse leveraged, investment results and intend to actively monitor and manage their investment as frequently as daily.
Sources:
https://www.investopedia.com/terms/e/etf.asp
https://www.nerdwallet.com/article/investing/what-is-an-etf
https://www.fidelity.com/learning-center/investment-products/etf/what-are-etfs
