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What is an Exchange-Traded Fund (ETF)?

| MoneyRates.com Senior Financial Analyst, CFA
min read
Used correctly, ETFs can help investors with relatively small portfolios implement strategies common to big-money investors.

 

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Exchange-traded funds, commonly known as ETFs, are an efficient way to make a variety of investments that can help diversify your portfolio.

Understanding how they work can open up a new form of investment tool for you.

You'll make the best use of that tool if you understand not only what ETFs are, but what to look for when you choose one and how to make them part of your investment strategy.

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What is an ETF?

"ETF" is an abbreviation for "exchange-traded fund." It's like a mutual fund except that it's traded on a securities exchange.

That's a rather technical definition; but to understand what that means, it helps to break down the individual characteristics of an ETF:

  • What does it mean to be a mutual fund?

    Mutual funds are investment vehicles in which investors pool their resources to buy a particular group of securities. This pooled approach allows you to get broad diversification in a large number of securities with just a modest investment.

  • What does it mean to be traded on an exchange?

    Where ETFs differ from traditional mutual funds is that they are traded on exchanges like stocks. This means their prices fluctuate throughout the day and they can be traded at any time. (Traditional mutual funds are more limited - their prices are only updated at the end of the trading day and they can only be traded at that end-of-day price.)

By combining these two characteristics into one investment product, an ETF allows you to buy a broad basket of securities at any time with the ease of buying an individual stock.

How Does an ETF Work?

Each ETF is designed to own a specific type of securities. So, for example, if your goal is to invest broadly in the U.S. stock market, you could do that by investing in an S&P 500 ETF. That would be a fund which holds all the stocks in the S&P 500 in the same proportions as they are represented in that index.

As investors buy or sell an ETF, the company managing the ETF must buy or sell individual securities within the fund. That management company is responsible for maintaining the holdings of the fund according to the stated objectives of that fund.

The expense side of ETFs

In return for doing this, the management company charges a management fee. There may also be other expenses associated with operating the fund.

The total of management fees and other expenses are included in what's known as an expense ratio. This is the total cost of operating the fund as a percentage of the fund's value.

This expense ratio is not charged to investors directly but, instead, comes out of the fund so it reduces the price of the ETF slightly over time. This is similar to how expenses are charged to a traditional mutual fund.

Types of ETFs

ETFs offer investors a choice of many different portfolios of investments. Broadly speaking, though, they break down into two types of approaches: passive and active.

Passive ETFs

A passive ETF is designed to imitate a designated market index. This type of investment is commonly referred to as an index fund.

The S&P 500 is a prominent example of an index that is replicated by some ETFs and mutual funds as an index fund. There are also index funds built around small cap stocks, international stocks and specific industry segments.

Passive ETFs are not limited to stock indexes. There are also ETFs designed to mimic certain types of bonds, commodities and other securities.

The main thing about a passive ETF is that the manager of the fund is not making decisions about which securities they think will do better or worse than others. They are simply responsible for managing the holdings of the fund so that it replicates the fund's assigned index as closely as possible.

Active ETFs

An active ETF is one where the fund's manager is making decisions based on their perception of which securities will do better than others.

The ETF may specify a type of strategy the manager is to follow in making these decisions, but ultimately there is some investment judgment involved. The manager is trying to beat the market, not mimic it.

Because the price of exchange-traded funds is determined by supply and demand in the market, the price of active ETFs can be affected by investor confidence in the manager's ability to beat the market. Thus, the market price of active ETFs may vary more widely from the underlying net asset value (NAV) than is usually the case for passive ETFs.

What is the Difference Between an ETF and a Mutual Fund?

Another way to understand investments is by exploring their differences. In the case of ETFs and mutual funds, the differences can be seen in terms of liquidity and how their price is calculated.

Liquidity

Exchange-traded funds offer more liquidity than traditional mutual funds because they can be traded at market prices any time throughout the day.

This added liquidity can be useful for implementing certain investment strategies, allowing the investor to be more responsive to market developments.

How price is determined

Another difference between ETFs and traditional mutual funds is that ETF prices are not directly based on the value of the underlying securities. This can create mismatches between their market prices and the underlying value of the securities they own.

With a traditional mutual fund, at the end of the trading day the value of all the securities held by the fund is calculated, any expenses are deducted, and then the remaining value is divided by the number of mutual fund shares.

The result is called a net asset value (NAV). This is the value of the fund per each share in the fund, and any trades for that day are made at the NAV price.

ETFs also have a NAV which represents the value of the underlying securities held divided by the number of shares in the fund. However, this is not the price at which purchases and sales of the ETF are made.

Because the ETF is traded on an exchange, prices are determined by supply and demand rather than directly on the value of the fund's underlying securities. While investors know roughly what the NAV of the fund is, it can be hard to determine exactly in the course of a day - especially when the market is moving up and down rapidly.

At times, then, the volume of sellers relative to the volume of buyers can cause the price of the ETF to vary from the NAV. If the market price of the ETF is greater than the NAV, the ETF is said to be trading at a premium. If the market price is lower than the NAV, the ETF is said to be trading at a discount.

Traditional mutual funds are not subject to these mismatches between the trading price and the NAV. However, because they are only traded once a day, a mutual fund's value by the end of the day might be different than it was when the investor placed the order to buy or sell.

What You Should Know About Investing in ETFs

Here are some things to consider before investing in ETFs:

1. Investment objective

Since there are so many types of ETFs, a key decision you must make is what type of investments you want to own.

The most fundamental choice is whether you want a passive ETF designed to mimic a certain market index or an active ETF designed to beat the market.

If you choose a passive ETF, you must decide specifically which type of market index you want to replicate. This could be stocks, bonds, commodities or other investments, and may involve a specific subset of those asset classes.

If you choose an active ETF, you should consider what investment strategy the fund will use to try to beat the market, and how successful the management company has been with that strategy in the past.

2. Expense ratio

Since management expenses take a direct bite out of the value of the fund, you should compare the expense ratios of different funds.

Generally speaking, the expense ratio of passive ETFs will be a lot lower than the expense ratio of active ETFs. That's because the passive manager's job is simpler - they are simply trying to replicate an index rather than figure out which securities are likely to do better than average.

With passive ETFs, you may be able to directly compare the expense ratios of funds designed around the same index to see which one is cheapest.

With active ETFs, you should consider the extent to which the manager's decisions have added value over and above the fund's expenses and how likely the manager is to continue that success in the future.

3. Tracking error

This is a key consideration for passive ETFs. Since a passive ETF is designed to mimic a certain index, you should look at how well the ETF has done at matching the performance of that index.

The difference between the performance of the ETF and the index it is assigned to replicate is known as tracking error. Expense ratios will account for some tracking error; but other than that, you should look for a passive ETF with as little tracking error as possible.

Using ETFs as Part of Your Investment Strategy

ETFs can be purchased individually through online brokers or they can be used by robo-advisors or an active manager as part of a broader asset allocation strategy.

In either case, you can either use narrowly defined ETFs as individual components to construct a portfolio or multi-asset class ETFs to achieve broad diversification across different markets with the purchase of a single fund.

However you buy ETFs, decide on your investment objective first to narrow down your choices. Then consider the expense ratio and track record of the fund in making your final decision.

Wherever you are in your financial journey, you can explore more options by selecting a financial goal below.

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