2.15 ETFs

Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) have become one of the fastest-growing investment products. They combine features of mutual funds and stocks, offering diversification with the flexibility of intraday trading. Understanding how ETFs differ from mutual funds is key for the SIE exam.

What Is an ETF?

An exchange-traded fund (ETF) is a pooled investment that trades on stock exchanges throughout the day, like individual stocks.

Key Features

Trading: Intraday on exchanges

Pricing: Market price (fluctuates continuously)

Management: Usually passive (tracks an index)

Minimum investment: One share

Transparency: Holdings typically disclosed daily

ETFs vs. Mutual Funds

Trading: ETFs - Throughout the day; Mutual Funds - Once daily (at 4 PM NAV)

Pricing: ETFs - Real-time market price; Mutual Funds - End-of-day NAV

Order types: ETFs - Market, limit, stop orders; Mutual Funds - Market orders only

Short selling: ETFs - Yes; Mutual Funds - No

Minimum investment: ETFs - Price of 1 share; Mutual Funds - Often $1,000-$3,000

Management style: ETFs - Usually passive; Mutual Funds - Active or passive

Expense ratios: ETFs - Generally lower; Mutual Funds - Generally higher

Tax efficiency: ETFs - More efficient; Mutual Funds - Less efficient

How ETFs Trade

ETFs trade like stocks on exchanges:

- Market orders: Execute immediately at current price

- Limit orders: Execute only at specified price or better

- Stop orders: Trigger when price reaches specified level

- Intraday trading: Buy and sell multiple times per day

Key Difference: Mutual fund orders execute at end-of-day NAV regardless of when placed. ETF orders execute immediately at current market price.

ETF Pricing

ETFs have two prices:

Market price: What you pay/receive when trading

NAV: Value of underlying holdings per share

Market price usually stays close to NAV, but can differ slightly:

- Premium: Market price greater than NAV

- Discount: Market price less than NAV

The Creation/Redemption Process

ETFs have a unique mechanism that keeps prices aligned with NAV:

Authorized Participants (APs)

Large institutional investors called authorized participants can:

1. Create ETF shares by delivering underlying securities to the fund

2. Redeem ETF shares by exchanging them for underlying securities

How It Works

ETF trades at premium: AP creates new shares; Supply increases, price falls toward NAV

ETF trades at discount: AP redeems shares; Supply decreases, price rises toward NAV

This arbitrage process keeps ETF prices close to NAV.

Tax Efficiency

ETFs are generally more tax-efficient than mutual funds due to:

In-Kind Redemptions

When APs redeem shares, they receive underlying securities (not cash). This means:

- Fund does not need to sell securities

- No taxable capital gains triggered

- Existing shareholders avoid unexpected tax bills

Mutual Fund Capital Gains Problem

Mutual funds must sell securities to meet redemptions, potentially triggering capital gains that are distributed to all shareholders - even those who did not sell.

Tax Advantage: ETF investors typically only realize capital gains when they sell their own shares, not from other investors' activity.

Types of ETFs

Index ETFs: Track market indexes; Example - S&P 500, Russell 2000

Sector ETFs: Focus on specific industries; Example - Technology, healthcare

Bond ETFs: Hold fixed-income securities; Example - Treasury, corporate bonds

Commodity ETFs: Track commodities; Example - Gold, oil

International ETFs: Invest in foreign markets; Example - Emerging markets, Europe

Actively managed ETFs: Portfolio manager makes decisions; Growing category

Advantages of ETFs

Lower costs: Typically lower expense ratios than mutual funds

Trading flexibility: Buy/sell anytime during market hours

Tax efficiency: Fewer taxable distributions

Transparency: Holdings disclosed daily

No minimum investment: Buy as little as one share

Diversification: Single trade provides broad exposure

Disadvantages of ETFs

Trading costs: Brokerage commissions (though many are now free)

Bid-ask spread: Cost embedded in price difference

Premium/discount: May not trade exactly at NAV

Overtrading temptation: Easy access can encourage excessive trading

Less suitable for dollar-cost averaging: Mutual funds handle fractional shares better

Key ETF Terminology

Authorized participant: Institution that can create/redeem ETF shares

Creation unit: Large block of ETF shares (typically 25,000-50,000)

In-kind transfer: Exchange of ETF shares for underlying securities

Indicative NAV (iNAV): Estimated NAV updated throughout trading day

Key Takeaways

- ETFs trade on exchanges throughout the day at market prices

- Mutual funds trade once daily at end-of-day NAV

- ETF creation/redemption process keeps prices close to NAV

- ETFs are generally more tax-efficient than mutual funds

- Most ETFs are passively managed with lower expense ratios

- ETFs offer trading flexibility: limit orders, stop orders, short selling