Financial Planning Blog

You finally feel like you understand mutual funds, but what are exchange-traded funds, or ETFs? It's not like they are new--you've probably been hearing about them for several years--but, you aren't quite sure how they are different from mutual funds, or whether you should be suspect. (And, with the financial services industry, you generally should be suspect.) You may have even seen some negative press regarding ETFs, leading you to believe they are not appropriate for conservative, "buy-and-hold", long-term investors.

What are ETFs?

Very similar to mutual funds, ETFs are registered investment companies that offer investors a proportionate share of a portfolio of stocks or bonds. Most ETFs track market indexes (e.g. the S&P 500 or Russell 2000) like an index mutual fund, and have the same qualities (low cost, diversification, tax efficiency, etc) that make them attractive to many investors. However, ETFs differ from traditional mutual funds in the way they are constructed, and more importantly to the individual investor, how they are bought, sold, and priced. ETFs are traded like individual stocks at any time during market hours through a brokerage account. Like individual stocks, ETF prices are constantly changing, and investors buy and sell at the market price at the time of the trade. Contrast this to traditional mutual funds where orders to buy and sell are taken during the day, but the transaction is completed after the close of the market, and the price is the net asset value (NAV) of fund. (Net asset value is calculated by dividing the total value of all the securities owned by the fund and dividing by the total number of mutual fund shares outstanding.) 

When investors buy and sell traditional "open-ended" mutual funds, they are actually making the transaction directly with the mutual fund company. The company sells new shares to investors, or redeems shares for cash from investors who wish to sell. If necessary, the fund may have to sell stocks or bonds within its portfolio in order to redeem shares upon request. This can have negative consequences if it forces an untimely sale of securities, creates excessive transaction costs, or causes the realization of capital gains that are then distributed to shareholders who are taxed on those gains.

The underlying construction of ETFs differs from mutual funds, and investors do not make transactions directly with the fund company. ETF shares, in big batches called creation units, are created by large institutions providing an exact, pre-defined basket of securities to the fund company. These large brokerages or investment banks then break these creation units down into smaller quantities and sell the new ETF shares via the stock exchange. When an individual wants to buy some ETF shares, he needs to buy some of these previously created shares. When an individual wants to sell some ETF shares he cannot redeem them from the fund company as he would a mutual fund, but he must find another willing buyer via the stock exchange. Redemptions from the fund company are only done in large batches--the creation unit process in reverse.

So far this is all pretty boring stuff, and it may be difficult to see how an ETF would benefit the individual investor. In Part 2 we'll look at a number of tangible benefits of ETFs and how you might use them in place of traditional mutual funds. We'll also look at some of the negative aspects to ETFs, and why some respected people are generally down on them.