Understanding ETFs: A Comprehensive Guide to Exchange-Traded Funds

A stock exchange-traded fund (ETF) is a listed investment product that captures a basket of assets that often tracks a popular stock index’s performance. As with a financial asset, an ETF is a fund that is traded at a market-determined price and allows an investor to trade shares based on an entire portfolio’s performance.

An ETF shares similar characteristics with mutual funds, and its prices change throughout the day, depending on demand and supply. ETFs are registered as a unit investment trust or open-ended investment company in line with the guidelines prescribed by the Investment Company Act of 1940.

The U.S. Securities and Exchange Commission (SEC)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges oversees the operations of ETFs. Exchange-traded funds are increasingly becoming the financial products of choice for different types of investors. By reflecting the market performance of a popular index, such as the S&P 500, an ETF provides a return proportionate to the index. It presents lesser risks to the investor because the pooled assets are very diversified.

Summary

• A stock exchange-traded fund (ETF) is an investment in a portfolio of multiple classes of stock with most of the investment and trading characteristics resembling those of a mutual fund and common stocks, respectively.
• ETFs’ prices and liquidity change throughout the day, unlike mutual funds whose net asset value is determined at the end of each trading day.
• ETFs offer multiple benefits to investors in terms of transference, low cost, tax relief, access to various parts of the market, and ownership of a pool of funds for investing.

Origin of Stock Exchange-Traded Funds (ETFs)

The history of ETFs can be traced to the concept of portfolio trading or program trading of the 1980s. The early portfolio trade enabled investors to trade shares of the major indexes using a single trade order.

Often, a portfolio consisted of all the S&P 500 stocks. Shortly after, the S&P 500 index futures contracts were introduced at the Chicago Mercantile Exchange, and they set the stage for traded portfolios and future stocks. The premise of such a development was to entice institutional investors through a trading portfolio and attractive future markets. Individual and institutional investors needed an SEC-regulated portfolio product.

In the early 1990s, SPY was floated in the American Stock Exchange (AMEX) as the first ETF to offer exchange-traded access to the major market index. However, the second ETF introduction in 1995 rendered ETFs as isolated financial products until 1996, when World Equity Benchmark Shares (WEBS) came into being under the management of Barclays Global Investors. The investment products rapidly grew to become an important part of ETF trading, and they now span various trading strategies and asset classesAsset ClassAn asset class is a group of similar investment vehicles. They are typically traded in the same financial markets and subject to the same rules and regulations..

Composition of ETFs

Initial ETFs were designed to keep track of the performance of specific equity indexes in the U.S. However, the new and the predominant type of ETFs seek to achieve a particular investment strategy. The modern ETFs are obliged to reveal information on their prior listing to the beginning of a trading day to facilitate valuation.

One feature that keeps ETFs aligned with fair value is that they can be created and redeemed at the end of each trading day. They are hybrid in that they combine mutual funds and the intraday trading features of closed-end funds. Nevertheless, ETFs can only be purchased and shared by retail investors in market transactions, rather than directly selling individual shares.

In order to buy shares from an ETF, an investor assembles and deposits a prospective portfolio of securities and cash with the fund, after which shares are given in exchange. The investor is then free to sell shares to market makers, institutional investors, or individual investors on a secondary market.

Types of ETFs

The two types of ETFs are index-based and actively managed ETFs. Index-based ETFs invest specifically in the index’s component securities, while the latter seeks to achieve a stated investment strategy. The indexed-based ETFs are designed to track specific market sectors, unlike the actively managed ETFs, which can be bought or sold daily without considering conformity with the index.

Benefits of Using ETFs as Investment Vehicles

ETFs offer investors broad advantages compared with other investment vehicles, including:

1. Access to various market areas at an extraordinarily low cost

The ETF industry makes up 12% of the U.S. $35.5 trillion stock market as of June 2020. Due to their low expense ratioExpense RatioAn expense ratio is a fee charged by an investment company to manage the shareholders' funds. Investment companies such as mutual funds often incur various operating expenses when managing investors’ funds, and they charge a small percentage on the funds under management to cover the expenses., ETFs expose investors to wide market areas at an extraordinarily low cost. For investors operating at the retail level, ETFs are cheaper compared to indexed mutual funds.

2. Opportunity to build new portfolios

Another core benefit of ETFs is the new portfolio construction opportunities. Investors can own a wide range of new asset classes for investment purposes, an opportunity that was difficult and costly before, except for institutional-based investors. ETFs are also subject to transparency regulations. By disclosing their portfolio daily, ETFs allow investors to know whether their portfolio is managed as per their stated investment objective.

3. Tax efficiency

Tax efficiency is another key benefit of ETFs. Their low after-tax returns spare investors the burden of the capital gains tax.

More Resources

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