What is an Exchange-Traded Fund (ETF)?

The definition of an Exchange-traded fund (ETF)
An ETF is a security that is marketable. It tracks an index, commodities, bonds and even a range of assets like an index fund. In contrast to a mutual fund, ETF trades are similar to common stocks on the stock exchange. Throughout the day, ETFs go through price changes when they are bought or sold. ETFs commonly have a daily liquidity that is higher and fees that are lower than mutual fund shares, which results in them being a more attractive alternative for the individual investors.

ETFs trade like stocks, so it does not have a net asset value (NAV) that gets calculated once at the end of each day, while a mutual fund does.

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Breaking down the Exchange-Traded Fund
An ETF fund owns the underlying assets, which are the shares of stocks, bonds, gold bars, or foreign currency, and it divides the ownership of the assets into shares. Depending on the country, the structure of the investment vehicle (for example a corporation or investment trust) can vary. Even within one particular company, there could be multiple structures that co-exist. The shareholders do not own directly or have any direct claim on the funds’ underlying investments. Instead, the shareholders indirectly own the assets.

The ETF shareholders are permitted to a proportion of the profits. These profits are earned interest or dividends paid. They can get a residual value if the fund happens to get liquidated. The fund’s ownership is easily purchased, sold or even transferred in the same way as the shares of stocks because the ETF shares get traded on the public stock exchanges.

The creation and redemption of ETF
The amount of ETF shares is regulated by the mechanism called creation and redemption. There are a few large and specialized investors that are involved in the process of creation and redemption. These dedicated investors are known as authorized participants (APs). The APs are made of big financial institutions that have a strong buying power, like market makers who could be banks or investment companies. The APs are the only ones who can create or redeem the units of an ETF. Once the creation happens, then the AP assembles the portfolio of the underlying assets required and turns that basket over to the fund to be exchanged for newly created ETF shares. Like for redemptions, the APs return the ETF shares to the fund, and they receive the basket that contains the underlying portfolio. Every day, the underlying holdings of the fund get disclosed to the public.

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ETFs and Traders

  • Arbitrage: Because both the ETF and the basket containing the underlying assets can be traded during the day, the traders can take advantage of the brief arbitrage opportunities. The price of the ETF is then kept close to fair value. If the trader can purchase the ETF for less than the underlying securities, then they can purchase the ETF shares and sell the underlying portfolio, by securing the difference.
  • Leveraged ETFs: some of the ETFs make use of gearing, or leverage, by the use of derivative products to be able to create the inverse or leveraged ETFs. The inverse ETFs track and monitor the opposite return of the underlying assets. An example is the inverse gold ETF that can gain 1% for each 1% drop in the metal price. The leveraged ETFs are set to gain many returns of that particular underlying. Two times of the gold ETF can increase 2% for each 1% gain in the metal price. Leveraged inverse ETFs can also be negative 2x or 3x return profiles.

The advantages of ETFs
With the ownership of an ETF, the investors can receive the diversification of an index fund in addition to being able to sell short, or buy on margin and purchase as little as one share (as there are no minimum deposit requirements). Another advantage is that the ratios for expense for most of the ETFs are less than the average mutual fund. When ETFs are bought or sold, one is required to pay the same commission to a broker that they would need to pay in a regular order.

There is the potential for favorable taxation on ETF generated cash flows because

the capital gains derived from the sales inside the fund do not pass through to the shareholders since they are often with the mutual funds.

Examples of widely traded ETFs

  • One of the most recognized and traded ETFs tracks the S&P 500 Index. It is called the Spider (SPDR), and it trades under the ticker SPY.
  • The Russell 2000 Index is tracked by IWN
  • The QQQ tracks the Nasdaq 100. The DIA tracks the Dow Jones Industrial Average.
  • The sector ETFs exist and follow the specific industries like oil companies (OIH), the energy companies (XLE), the biotech sector (BBH), and more.
  • Commodity ETFs exist to be able to track the commodity prices which include gold (GLD), crude oil (USO), and others.
  • The ETFs that track the foreign stock market indices exist for many of the developed and emerging markets, in addition to other ETFs that track the worldwide currency movements.