ETFs, what are they & how do they work?

TL;DR

• Exchange-traded funds (ETFs) are investment funds that trade like stocks on exchanges.
• ETFs have fluctuating share prices that can change throughout the day, unlike mutual funds which only trade once a day after the market closes.
• ETFs can hold a wide range of investment types including stocks, commodities, or bonds and can have a focus on either U.S.-only holdings or international holdings.
• ETFs have low expense ratios and lower broker commission costs compared to purchasing individual stocks.
• ETFs can follow a specific investment strategy, a theme, follow an idea or be actively managed.
• ETF units are created and redeemed by authorised participants (AP).

What is an ETF?

Exchange-Traded Funds (ETFs) are investment vehicles that allow individual investors to access a diverse portfolio of stocks, bonds, commodities, or other assets in a single, low-cost instrument. Unlike mutual funds, ETFs trade on an exchange like individual stocks, allowing investors to buy and sell shares throughout the trading day at prices that reflect the current market value of their holdings.

ETFs are comprised of a basket of underlying assets, which can include anything from blue-chip stocks to emerging market bonds to commodities like gold and oil. This diversity makes ETFs an attractive option for investors looking to diversify their portfolios, as well as for those who want to gain exposure to specific markets, industries, or investment styles.

Types of ETFs

There are several types of ETFs, some ETFs focus on a single asset class;

1. Bond ETFs: These investment vehicles aim to provide regular income to investors by tracking the performance of a basket of bonds, which can be government bonds, corporate bonds, or municipal bonds. Unlike the bonds themselves, bond ETFs do not have a maturity date and generally trade at a premium or discount from the actual bond price.
2. Stock ETFs: Stock ETFs are funds that hold a basket of stocks, allowing investors to gain exposure to a single industry or sector, such as the automotive or foreign stock markets. They offer low fees and no direct ownership of securities, providing diversified exposure to a single industry.
3. Commodity ETFs: Commodity ETFs invest in commodities, such as crude oil or gold, and provide diversification for a portfolio, as well as lower costs for physical commodity ownership. They can serve as a cushion during a stock market downturn.
4. Currency ETFs: Currency ETFs track the performance of currency pairs and can be used for speculation, portfolio diversification, or as a hedge against forex market volatility by importers and exporters. They can also provide a hedge against inflation.

There are strategy based ETFs as well, for example;

1. Thematic ETFs: These ETFs are designed to track a specific theme, such as clean energy, technology, or healthcare. Thematic ETFs allow investors to invest in companies that align with their values or interests, and they can provide exposure to a wide range of companies in a growing and dynamic sector.
2. Active ETFs: Unlike passive ETFs, which track a specific index, active ETFs are managed by professional portfolio managers who make investment decisions on behalf of the fund. Active ETFs aim to outperform the market by using a variety of investment strategies, including security selection, market timing, and risk management.
3. Passive ETFs: Passive ETFs track a specific market index, such as the S&P 500, and seek to replicate its performance. Unlike active ETFs, passive ETFs do not rely on a portfolio manager's investment decisions, but instead rely on a set investment strategy designed to track the index as closely as possible. Because of this, passive ETFs often have lower expense ratios than active ETFs.
4. Inverse ETFs: Inverse ETFs aim to profit from stock market declines by shorting stocks through the use of derivatives. They are a bet on the market's decline, but investors should be aware that many inverse ETFs are actually exchange-traded notes (ETNs) and not true ETFs.
5. Leveraged ETFs: Leveraged ETFs aim to return multiples of the return of the underlying investments, such as the S&P 500, through the use of derivatives like options or futures contracts. They also have inverse leveraged ETFs, which seek an inverse multiplied return.

ETF Cost and Taxes

Another advantage of ETFs is their low cost structure. ETFs typically have lower expense ratios compared to Mutual Funds. This makes them an attractive option for cost-conscious investors.

Because ETFs are sold and bough on the open market like shares, the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy.

Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund. Therefore ETFs offer tax efficiency, as they are structured in a way that minimizes capital gains taxes.

Creation and Redemption of ETFs

ETFs are created and redeemed through a process known as "Creation Units". This process is managed by authorized participants, who are typically large financial institutions such as banks or broker-dealers.

When an ETF provider wants to issue new shares of an ETF, they do so by creating new Creation Units. To do this, the authorized participant delivers a basket of underlying assets to the ETF provider in exchange for a block of new ETF shares. The AP then sell these new ETF shares on the market, making them available for purchase by investors.

The reverse process, redemption, occurs when an authorized participant wants to sell a block of ETF shares back to the ETF provider. To do this, the authorized participant returns the ETF shares to the provider in exchange for the underlying basket of assets. This allows the ETF provider to retire the ETF shares and manage the supply of the ETF.

Creation and redemption play a critical role in keeping the supply and demand of ETF shares in balance, and helps ensure that the ETF's market price remains closely aligned with the net asset value of its underlying assets

Creation in ETFs when Shares Trade at a Premium

Consider an ETF that invests in the stocks of the S&P 500 with a share price of $101 at the end of the market. If the value of the stocks the ETF owns is only worth $100 on a per-share basis, then the fund's price of $101 is trading at a higher value than the fund's net asset value (NAV). The NAV is a calculation mechanism that determines the overall worth of the stocks or assets in an ETF.

An authorized participant (AP) is motivated to align the ETF share price with its NAV. To do so, the AP will purchase shares of the stocks that the ETF aims to include in its portfolio from the market and sell them to the fund in exchange for ETF shares.

In this scenario, the AP is acquiring stocks from the open market worth $100 per share but receiving ETF shares trading on the open market for $101 per share. This process is referred to as creation and increases the number of ETF shares available on the market. If everything else remains constant, increasing the supply of shares will lower the price of the ETF and bring the shares in line with the NAV of the fund.

ETF Redemption

On the other hand, an AP can also purchase ETF shares on the open market and then sell these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. This process, referred to as redemption, reduces the number of ETF shares available.

The level of redemption and creation activity is determined by market demand and whether the ETF is trading at a discount or premium compared to the value of the fund's assets.

Redemption When Shares Trade at a Discount

Suppose an ETF holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks held by the ETF is $100 per share, then the ETF is trading at a lower value than its NAV.

To bring the ETF's share price back to its NAV, an AP will buy ETF shares on the open market and sell them back to the ETF in exchange for shares of the underlying stock portfolio. In this case, the AP is able to purchase ownership of $100 worth of stock by exchanging ETF shares that it bought for $99. This process is known as redemption, and it decreases the supply of ETF shares available on the market. When the supply of ETF shares decreases, the price should rise and approach its NAV.

Dividends and ETFs

Investing in ETFs can offer not just the opportunity to benefit from stock price movements but also from the dividends paid by companies. Dividends are a share of a company's earnings that are distributed to its stockholders. As a shareholder of an ETF, you are entitled to a portion of the profits in the form of dividends or earned interest, and in case the fund is dissolved, you may receive a residual value dividend.

Risks of Investing in ETFs

Counterparty Risks in ETFs

Investors are advised to assess the counterparty risks when entering into an ETF, as a heavy reliance on a counterparty can put the investor's principal at risk, and counterparty failures can affect the economic exposure of the fund. Examples of counterparty risks include settlement risks and security lending.

Settlement Risks: This risk is common in ETFs that use over-the-counter derivatives and refers to the losses incurred due to counterparty risk. Frequently settling over-the-counter contracts can help manage settlement risks by minimizing exposures to swap partners in case of bankruptcy.

Security Lending: In some cases, ETF managers may lend out their securities to borrowers (short-sellers), who are then required to replace the security later through a purchase. If the borrower fails to meet their obligation, the fund is at risk, which can be mitigated by over-collateralizing the lent securities.

ETF Fund Closures

ETFs, like any other fund, may close. This occurs when the underlying securities of the fund are sold, and cash returns are made to investors. Fund closures can be caused by regulations governing the funds, increased competition, corporate actions, creation halts, or changes in investment strategy.

Regulations: Changes in the regulations governing ETFs can result in fund closures, such as a sudden increase in interest rates that may jeopardize the fund's operation.

Competition: The rapidly rising number of ETFs has led to increased competition, leading to the closure of many funds with smaller trading volumes that are not attractive enough to investors.

Corporate Actions: Fund closures can also result from mergers and acquisitions from one ETF provider to another, where the new owners may choose to shut down underperformers to pursue new growth opportunities.

Creation Halts: At times, a fund may stop selling from its inventory, halting further creation and redemption of shares. This can cause the fund to trade at a premium against the fair price, and is commonly seen in exchange-traded notes (ETNs).

Change in Investment Strategy: Instead of closing a fund and opening another one, ETF managers may opt to change the underlying index of the fund. Although this might seem easier, it can cause virtual closures.

Investor-related Risks

Investors who do not understand the ETF's exposures and performance are at risk. Investors must therefore evaluate the fund's index methodology and portfolio construction approach. This risk is most prevalent in leveraged and inverse exchange-traded funds.

Bottom Line

Investing in ETFs is an efficient way to diversify your portfolio and have exposure to a range of securities with a modest amount of capital. By purchasing shares of a fund that aims to track a comprehensive cross-section of the market, you avoid the hassle and cost of buying individual stocks. Nevertheless, it's crucial to consider the risk & costs associated with investing in ETFs.

Until next time!

Karan Madan

May the force be with you!