Exchange Traded Funds
Exchange traded funds, commonly known as ETFs, are a hybrid investment that has features of both a stock and a mutual fund. It is a collection of managed assets, like a mutual fund, but also trades on an exchange, like stocks.
When you buy and sell a mutual fund, you put an order in which gets executed for you at a later time, perhaps later that trading day or the next trading day. Mutual funds are valued by the value of the assets it holds at the end of each trading day, whereas ETFs are traded actively, on a moment to moment basis on exchanges, just like one would buy common stock.
ETFs may track indexes, or consist of a a basket of stocks or bonds, commodities, currencies, derivatives, and even a basket of ETFs. So the application for ETFs is very broad, as broad as you can get really, and the only limit to ETFs is having enough marketability to have a certain type put together.
In the case of both mutual funds and ETFs, the funds are assembled and managed, and this can either be by way of active or passive management, with passive management involving just looking to mirror an index.
Fund companies assemble and manage mutual funds, and then investors buy and sell units of the fund through dealers. ETF shares are created and redeemed by large market participants, such as banks and other large financial institutions, known as authorized participants, or APs.
So the AP would turn over assets to the fund in exchange for shares, and would also redeem their shares for the assets, and this is how assets flow in and out of ETFs. Individual investors are not involved in this process at all, and never take possession of any of the assets, as this is all done for them by the APs, who serve as market makers in this process.
ETFs offer both greater liquidity, from both the sheer trading volume of them as well as the ease and timeliness that one may buy and sell shares of ETFs, as well as lower management costs. Given this, it’s no wonder why this type of financial instrument has become so popular over the last few years.
A lot of people also simply like to do their own trading, and feel that ETFs represent the best of both worlds between trading stocks and investing in mutual funds, with all the advantages of mutual funds but with the convenience of trading shares of it on an exchange.
Pricing of ETFs
With ETFs, shares are actively traded throughout the trading day, and while the pricing of them is ultimately based upon the value of the underlying assets, this is not direct like mutual funds, but indirect.
What happens with ETFs is that, while the price of the shares are determined in the same way as common stock, by supply and demand, by bid and ask essentially. If the price deviates very much from the value of the underlying assets, then arbitrageurs will swoop in and either buy and sell the ETF if an opportunity exists to make a profit by taking an opposite position in the underlying assets.
To provide a simple example of this, if the ETF tracked a stock index, and it became a bargain to buy the ETF over buying the individual stocks, then this would increase demand for the ETF by people who look to capitalize on these discrepancies, so this would serve to drive the price back up to where it was close enough to the ETF’s actual value so that a profit could no longer be made.
It doesn’t take much to make a profit this way by the large institutions that seek to arbitrage this market, and we’re talking big financial institutions doing this, so this process serves to keep the price and the value in line, which adds stability to the pricing of ETF’s, at least relative stability to the value of the assets.
This all goes on behind the scenes, and individual investors aren’t even going to be aware of any of this, but on the other hand it’s nice to not get stuck with a position where you’ve overpaid by a significant amount for the ETF, and have to worry about that risk, or worry about calculating such things. This would be virtually impossible to do anyway on a moment by moment basis with the resources individual investors have at their disposal.
So with the knowledge that the pricing of ETFs will be in line with their market value, investors can just go ahead and buy and sell shares of ETFs in order to execute whatever strategy they are seeking.
What ETFs Really Bring To The Table For Investors
Even if an individual investor is trading full time, and there are some who actually do this from home, if you trade in individual assets, you are going to be fairly limited. This will take both a huge portfolio and a lot of resources to pull off, and even then, you’re not going to even come close to the diversification and management that a fund can achieve.
This is why people resort to funds in general, although this isn’t to say that people should always be investing in funds and not individual assets, and diversification is just one consideration here, and one that may not even be that significant, depending on the circumstances.
If you’re looking to speculate on gold for instance, or on a currency, then this can be a pretty simple matter, and you aren’t even looking for any diversity here at all. The same can be true of anything, and trading in a single stock may be completely in line with your goals, if you don’t need or want to spread the risk.
There are a lot of considerations that go into whether one trading strategy may be preferable over another actually. With a lot of more casual investors, particularly the ones that really don’t have much time or resources to devote to trading, it is wise and very often absolutely required that they give over the management of their assets to a third party.
So this is where funds come in, and they serve to take care of that need very well, particularly for those whose portfolio size is way too small to merit private management, and it takes a very large one for this to be feasible. Some may want to exercise some degree of active control over the process though, where they may be between the passive investor who just wants to give it all over to a mutual fund, and an active trader who wants to do it all themselves.
So the real beauty of ETFs is that they do allow for people to actively trade them, while at the same time trading shares in be professionally managed.
When you add to this the ability to trade on margin and to sell short, advantages that trading stocks have but investing in mutual funds do not, it’s easy to see why many investors find ETFs so appealing.
Types of ETFs
There are a lot of different ETFs out there in the market, including a lot of different types of ETFs, much like there are a lot of mutual funds, and the goal with both is to carefully select the right ones that best suit one’s investment objectives, in addition to selecting ones that are more likely to appreciate in value over the time frame chosen.
ETFs that track major stock indexes, such as the S&P 500, the Dow, and the Nasdaq 100, are the most popular forms of ETFs. This allows people to not only buy and sell the entire basket of stocks in this index, it also offers a lot more transparency as to the value and movement of the underlying assets, which can also be easily charted.
You can also trade ETFs which track non U.S. based stock indices, and this type of ETF has really risen in popularity lately.
Sector ETFs are also fairly popular, with each tracking equities in a particular business sector, like the energy business, financial companies, real estate companies, and so on.
One can also buy and sell ETFs based upon commodities, such as gold, silver, oil, and so on, and this allows people to get ready access to the commodities market, without actually directly trading in market futures. The ETF does though of course, although in a way that is extremely simplified for individual investors, they just buy and sell shares in the ETF.
You can trade in a particular ETF or you can trade with ETFs that consist of groups of ETFs. This allows you to diversify your holdings even more, and get involved in a lot of things with just one single trade.
You can sell short with ETFs, which means borrowing the shares from other investors and agreeing to purchase them at a later date to repay the share loan, and this is seen by many as a very appealing feature of ETFs. Instead though one could simply purchase shares of what are called inverse ETFs, which by their nature take short positions in assets, and this not only makes fading markets easier, it does not even require a margin account, as short selling does.
There are even more types of ETFs, such as double gold ETFs which double the profit and loss relative to gold prices, where the ETF itself trades this on margin, and ETFs can trade on margin without the investors needing to.
One can also trade in what are termed synthetic ETF’s, which use swaps to look to emulate a collection of assets, without taking a position in them. This type of ETF tends to concern regulators though due to what’s called counterplay risk, the risk that the counter parties who the swaps are with may not fulfil their obligations.
ETFs are becoming more and more popular with investors and traders all the time, for some very good reasons.