ETFs offer diversified, cost-effective investing, with daily liquidity and tax efficiency. SPY, for instance, tracks 500 stocks, enhancing portfolio stability.
Definition and Structure
What is an ETF?
Basically, ETF stands for Exchange Traded Fund, which is an investment fund and an exchange-traded product. You can trade ETFs on the stock exchange, similar to shared investments. They allow investors to pool resources and get a diversified portfolio without having to buy each asset individually.
Structure of ETF
Open-ended funds mean that they can issue and redeem shares at any time, just like any other regular mutual fund. This is how the price of an ETF is aligned with the net asset value (NAV) of its underlying assets.
- Creation and creation process: This process requires the participation of large institutional investors called APs (Authorized Participants). ScrollBars Authorized Participants can deliver a basket of ETF underlying securities to the ETF provider to create new ETF shares. Or, conversely, they can “create” more ETF shares (or redeem additional shares) by receiving (or returning) already activated securities.
- Physical Trading: ETF can save taxes because the creation and redemption of shares are in the form of securities rather than cash, which allows ETF to minimize capital gains taxes. This tax efficiency is a huge advantage over traditional mutual funds.
Types of ETFs
There are many different kinds of ETF, all created to meet different investment objectives:
- Stock ETF: Monitor an index like the S&P 500 or the Nasdaq 100. Example: Vanguard Total Stock Market ETF (VTI)
- Bond ETF: You can invest in all types of bonds, including government bonds, corporate bonds, and municipal bonds. Example: iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
- Sector and Industry ETF: Focus on a specific industry or sector, such as technology, healthcare, and energy. Is XLK one of the largest sector ETF?
- Commodity ETF: The best example here is investing in gold, silver, or oil. Example: SPDR Gold Shares (GLD).
- International ETF: These give investors access to markets outside the U.S. Example: EEM – iShares MSCI Emerging Markets ETF.
Benefits of ETF
ETFs have many benefits that make them an attractive option for investors, including:
- Diversification: ETF allow investors to buy a “basket” of assets, which provides instant diversification and reduces risk in individual stocks or bonds
- Cost-effective: ETF typically have lower expense ratios than mutual funds. Take expense ratios, for example: the average expense ratio for ETF is about 0.44%, while the average expense ratio for mutual funds is about 0.74%.
- Flexibility: ETF can be bought and sold at market prices throughout the trading day, providing liquidity to individual stocks. Because they can be traded intraday, investors are able to respond quickly to market changes.
- Tax efficiency: The creation/redemption process of ETF reduces capital gains distributions, making ETFs a taxable investment vehicle compared to mutual funds.
How ETF Trade
Trading Mechanics of ETF
ETFs trade on major stock exchanges, similar to trading of individual stocks. ETFs allow investors to buy and sell shares at market prices during the trading day. ETFs and their liquidity: ETFs are known for their liquidity, which allows investors to enter and exit positions quickly.
Bid-ask spread: The difference between the price a buyer is willing to pay for a share and the price a seller is willing to sell it for. The spread indicates to investors how relatively cheaper it is to clear and trade. For example, when trading volume is high and the ETF is highly liquid, the bid-ask spread may be only a few cents, as is the case with popular ETFs like SPY.
Market vs. limit orders: Investors can place a market order to buy or sell ETF shares immediately at the current market price, or place a limit order to determine the highest or lowest price they are willing to trade at. Limit orders become useful during volatile times because they provide greater control over the execution price.
Comparison with Mutual Funds
Mutual funds are priced once at the end of the trading day (NAV or Net Asset Value), while ETFs are priced continuously during the trading day. This real-time pricing allows investors to enter and exit the market more quickly and provides additional flexibility in portfolio management.
Day Trading: Since ETFs trade on the open market, they offer all the features of stock trading, including boom shorting and leverage. For example, for an investor, if he buys shares of an ETF in the morning and then sells them at the end of the day… then that is day trading. Executioner Profits BUG
Liquidity and Pricing
The credit risk of an ETF comes from the underlying assets, and the trading volume of the ETF itself provides liquidity. Increased trading volume generally produces narrower bid-ask spreads, which ultimately means better prices for investors.
For example, the SPDR S&P 500 ETF (SPY) is one of the most heavily traded ETFs, with daily trading volume often exceeding tens of millions of shares. Due to high liquidity, investors who hold SPY shares can easily buy and sell any number of SPY shares without affecting the market price of SPY.
Price Discovery: The price of an ETF fluctuates throughout the day based on market conditions, reflecting significant price discovery. Pillar One: The Key Price Discovery Process Unfortunately, the price discovery process for these key investment vehicles occurs throughout the trading day.
Arbitrage Opportunities: When the market price of an ETF deviates from its NAV, there is an opportunity for APs to exploit this difference through arbitrage. However, when an ETF is trading below its NAV, arbitrageurs can buy ETF shares almost risk-free while simultaneously selling the underlying assets. This process helps keep the ETF price close to its NAV.
Price and Holdings Transparency
Given that ETFs are required to report their holdings daily, investors benefit from some transparency into the underlying assets. This transparency makes it easier for investors to make sound decisions about the ETF and ensure that the ETF itself is effectively following its target index or strategy.
Daily Holdings Disclosure: ETF providers provide detailed information on the largest percentage of ETFs every day of the week on their websites, with a full list of their holdings displayed on the website. This level of transparency is unparalleled in investing, allowing clients to know exactly what they own at any time.
For example, data is published daily for the iShares Core S&P 500 ETF (IVV), which holds all 500 stocks in the S&P 500 index. Investors can easily access this information, providing insight into the composition and performance of the ETF.
Liquidity Providers: Market Makers and Authorized Participants (APs): Market makers and APs (creation and redemption) are an important part of the ETF ecosystem, providing the necessary liquidity and efficiency. ETF shares are created and redeemed by APs so that the market price remains close to the NAV.
For example: If more investors want the ETF, the AP can buy the underlying securities and give them to the ETF provider, who can then issue new shares. The provider will also give shares of the ETF to investors at other times in exchange for the investor bringing the underlying assets to the provider, similar to exchanging goods back to the manufacturer.
Benefits of Investing in ETF
Diversification
When you buy an ETF, you instantly diversify through the basket of different assets that the ETF holds. This can reduce the inherent risk associated with holding specific stocks, with gains in certain securities offsetting losses in others. A great example is a broad-cap ETF, such as the Vanguard Total Stock Market ETF (VTI): this fund includes thousands of stocks across multiple sectors, giving you exposure to the entire U.S. stock market.
Quantitative Insights: With VTI, you get access to asset classes in over 3,600 stocks in one share. This kind of diversification would be nearly impossible if you were buying individual stocks, not to mention very expensive.
Cost-Effectiveness
One of the main benefits of ETFs is reduced costs. Another advantage of using ETFs is lower expense ratios relative to mutual funds. The average expense ratio charged by ETFs is about 0.44%, compared to 0.74% for mutual funds.
For example, the Schwab U.S. Broad Market ETF (SCHB) is priced at just 0.03%, making it one of the best value options for investors. Over time, these lower costs really start to work in your net return.
Flexibility and Liquidity
Since they trade like stocks, ETFs can be bought and sold during the trading day. This intraday trading flexibility allows investors to respond immediately to market conditions and adjust their portfolios accordingly.
Liquidity: Since ETFs trade in high volumes, investors can easily enter and exit positions without much impact on market prices. The spread between the buy and sell costs is typically smaller for frequently traded instruments, such as the SPDR S&P 500 ETF (SPY), which routinely trades millions of shares per day, providing ample liquidity for both large and small investors.
Tax Efficiency
Tax advantages are the main reason ETFs are structured significantly differently than typical mutual funds. ETFs are inherently more tax efficient than mutual funds because they are created and redeemed in-kind. This process helps minimize capital gains distributions.
Over the past decade, ETFs have averaged less than 2% in capital gains distributions per NAV, compared to more than 6% for mutual funds. This can translate into significant additional after-tax returns for investors.
Transparency
ETFs are very transparent because they are required to disclose their holdings on a daily basis. For investors, they can see exactly what assets are included in the ETF, making it easy to make decisions.
For example, the iShares MSCI Emerging Markets ETF (EEM) updates its holdings every day, giving investors a very transparent view of how much exposure to emerging market stocks they have. But this is a good thing, as it gives investors a clear understanding of the risk and reward profile of their investments.
Common Misconceptions
Key Differences Between ETF and Stocks
A common misconception among many investors is that ETFs and stocks are essentially the same thing, especially since both are traded on stock exchanges. ETFs trade like stocks, but in this case, they offer a degree of asset diversification rather than ownership in a single company. From another perspective, if you buy a single share of the SPDR S&P 500 ETF (SPY), you are interested in 500 unique companies, whereas with Apple stock (AAPL), you know you are only buying into 1 company.
Quantitative Insight: Since SPY is spread across 500 companies, if any one company suffers, investing in it will not hurt the overall investment.
Misconceptions About ETF Risk
A common misconception is that all ETFs are highly risky. The risk level of an ETF depends on its underlying assets. For example, ETFs that track a broad market index like the S&P 500 (SPY) are generally less risky than industry-specific or leveraged ETFs.
ETF vs. Individual Stocks
Other investors say ETFs can never outperform scarce individual stocks. While one can earn more from individual stocks, they also contain higher risks. ETFs, in contrast, enable a balanced trading model that combines growth potential with diversification.
Quantitative Insight: VTI offers a stable return profile with less risk than most individual stocks; from 2011 to 2021, the average annual return was nearly 14.2%.
ETF Costs Explained
It’s also a mistake to think that ETFs are always cheaper than mutual funds. While ETFs typically have lower expense ratios, trading costs can’t be ignored. These include brokerage commissions and bid-ask spreads.
Quantitative Insight: A $5 commission per trade may not seem high, but if an investor makes 10 trades a year, total trading costs can quickly add up to $50—a sum that can cost amateur investors who invest only a few hundred dollars (or even less in some cases) big, if not irrecoverable, dollars.
Myths of Leveraged and Short ETF
Leveraged and Inverse ETFs are often misunderstood. As such, these ETFs seek to provide twice the daily return of a benchmark index (leveraged) or an inverse index (inverse). Due to their compounding effect, they are period-specific instruments and are not designed for long-term investing.
Quantitative Insight: The intra-month effect of compounding, as we have seen in our work, weighs on intra-month performance. A 10% drop in the Nasdaq 100 in a month could cause TQQQ to drop by more than 30% (daily volatility).
