ETFs (exchange traded funds) are similar to mutual funds in that they typically hold stocks, bonds, etc. all in one investment product with one ticker symbol. ETFs are structured to follow an investment strategy. There are hundreds of ETFs available with the majority assigned a Morningstar category to help you determine the general investment straetgy of the ETF. Historically, ETFs have been used to gain low cost passive exposure to broad market indices (S&P 500, NASDAQ, Dow Jones, bond markets, etc.). For example, you can now invest in the entire S&P 500 Index for less than 0.05% in some available ETF products. Now, an increasing number of ETFs provide more nuanced areas of the market and some ETFs are actively managed like a mutual fund.
Transparency
For most ETFs, regulations for ETFs require ETF providers to share their investment holdings on a daily basis. That way you know what investments you hold in your ETF. All you need to do is go to the ETF provider’s website and take a look. Since many ETFs track an index and if the investments in the index don’t change all that much, the full transparency isn’t that much of an issue for ETF providers. Investors are getting the packaged product of all these investments and the ETF provider is getting paid to package and manage these investments in the ETF wrapper. Everyone wins.
There are some ETF providers that can offer semi-transparent ETFs. These ETFs tend to be actively-managed ETFs, rather than passive, index-tracking ETF strategies. Since the active manager has proprietary methodologies to select investments, they do not want the investing public (i.e. hedge funds trying to take advantage) to know what the investments are at every given moment. If everyone knew what the manager was doing, then their investment edge and potential outperformance is taken away. For this reason, some actively-managed ETFs do not have daily transparency into their holdings. Just something to be aware of.
ETF Premiums/Discounts
ETFs are funds where shares are created or destroyed (redeemed) to allow more or less shares available to be traded on exchanges. We won’t go into detail into the creation/redemption process as most won’t be able to take advantage of this (generally only institutional investors would). What you should know though, is that since the ETF is a fund that trades on an exchange intra-day, there is an inherent premium/discount of the ETF that investors need to be aware of.
Premiums and discounts refer to the difference in the share price of the ETF and the actual net asset value of the fund itself. The best managed ETFs will attempt to keep the premium/discounts very low.
Let’s say the underlying investments in the ETF is $100 million. If there are 1 million shares, all else equal, the share price of the ETF should be $100 per share. If there is a ton of demand for that ETF for any reason over a short period of time (intra-day), the share price may rise to $102 intra-day, which is actually higher than the actual value of the ETF’s investments. That extra $2 is considered a premium to the ETF’s net asset value (NAV). When there is a premium, the ETF provider needs to work with market participants to increase shares and/or buy more investments to get the value of the underlying assets to $102 per share. Same thing on the other side when a discount to NAV occurs. If investors desparately want to sell an ETF intra-day and the share price falls to $98 per share, but the value of the investments remains $100 per share, there is a discount created. To get the ETF’s NAV closer to the share price, the ETF provider will work to sell the undelrying investments and reduce the shares available for the ETF.
So when you are buying and selling ETFs, try to make sure you’re not buying ETFs when there is a significant premium (overpaying) or selling when there is a significant discount (not getting your full value). On the other hand, if you can buy an ETF at a significant discount to its NAV and sell it when its trading at a large premium NAV, you can trade this for added returns. ETFs are really tough to execute this as tight premiums/discounts are a sign of a quality run ETF, but premiums and discounts in closed end funds (which we will touch on in another lesson) are a well-known more persistent feature to potentially take advantage of.
Trading
ETFs trade on finanical exchanges and can be traded throughout the trading day. This is different than mutual funds that only trade at the end of the trading day. If you are a short-term trader or feel the need to get in and out of an investment at a specific time during any particular day, ETFs are a great way to do that. If you are a longer-term investor, in general, the time of day will rarely matter.
Frankly, the volatility of the markets provide investors a false sense of protection being able to sell out of an ETF when the market declines quickly in a particular day, but often that extra flexibility in timing intra-day ETF trades doesn’t always work out. Just because you can trade an ETF frequently intra-day, doesn’t mean you should.
Transaction Costs
If you are buying/selling ETFs on your own, there may be trading costs associated with doing so. It really depends on the brokerage firm you are working with. Some firms charge transaction fees on ETFs, some do not, and some only have a specific list of ETFs that they will trade without a transaction fee. This is sometimes called NTFs or “no transaction fee” ETFs.
Bid-Ask Spreads
When you trade ETFs on an exchange, there is a bid-ask spread which lists what you can sell the ETF for (the bid price) and buy the ETF for (the ask price). The bid price is the ETF share price what investors are willing to pay for the ETF and what you can get when you sell the ETF. The ask price is the ETF share price that investors are willing to sell the ETF for and what you will have to pay to purchase the ETF. The bid-ask spread is an additional “cost” for trading the ETF. The wider the difference between the bid price and ask price (the bid-ask spread) the higher the cost between when you buy and sell the ETF, assuming you made the buy and sell instantaneously. The actual share price of the ETF that you see on various financial websites or on your brokerage trading platform, is essentially the midpoint of the bid-ask price.
Typically, larger funds that have a lot of trading volume will have tight bid-ask spreads. It might be a difference of $0.01 or $0.02, which is the “cost” of the trade if you made the buy sell trade instantaneously. ETFs that are smaller and/or do not have a lot of trading volume, may have much wider bid-ask spreads, which can be a substantial cost. If the bid-ask spread is $0.20 on a $10 ETF, that’s a 2% “cost” for buying/selling the ETF. If you are an active trader, those costs can add up quickly everytime you do a trade. Be careful on these low volume, high bid-ask spread ETFs.
Fees
Just like mutual funds, ETFs have expense ratios that include all fees associated with managing the ETF. Unlike mutual funds, there is no “sales charge” based on different share classes to worry about.
Taxes
ETFs are structurally created to be more tax-efficient than other investment products, particularly mutual funds. For the most part, the capital gains taxes that you will encounter will be based on the share price you bought the ETF at and what you sold it at, hopefully for a gain. You’ll also pay taxes on any income that the ETF generates from dividends, bond interest etc. Through the ETF creation/redemption process, the impact of acquiring/disposing of investments in the ETF is tax efficient. This is different from mutual funds where investment positions are bought and sold for a gain or loss and any capital gains are paid by the shareholders themselves. For these reasons, in most market environments, ETFs are relatively more tax-efficient than other options.
Summary
In summary, ETFs are a great way to get low cost exposure to various asset classes, with strong transparency and ease of trading. Be aware of the nuances and additional potential trading fees associated with ETFs and you’ll be fine.