ETFs as an investment vehicle offer several benefits. As with all other investment decisions however, risk is involved, and investors should seek their own financial, legal and tax advice prior to purchasing any securities.
Cost Effective Diversification
Portfolio diversification can be an important investing principle for investors. Diversifying within and across various asset classes may help to reduce portfolio risk. ETFs can make portfolio diversification easier. Through their basket of underlying securities, they provide access to most major asset classes, sectors and geographic regions as well as many key investment strategies. Owning one broad market equity ETF, for example, provides investors with exposure to a large number of individual stocks. The cost of an ETF is generally lower than if one were to buy each stock individually. Attempting to build a diversified portfolio by buying individual stocks, bonds, commodities or other investments can be more costly, risky and time consuming than diversifying with ETFs.
Most ETFs are highly transparent in that they publish their holdings daily and typically disclose their relative weighting in the fund allowing investors to know if the fund has changed its position in any particular investment. In contrast, mutual funds generally disclose their holdings less frequently, typically quarterly. The transparency of ETF holdings allows investors to better understand the exact make up of their portfolio at any given time. In addition, because ETFs trade on an exchange, investors can more readily find the current market price.
Like stocks, ETFs trade on major stock exchanges around the world. When you buy or sell an ETF, you typically do so at the then current market price. This can be done through an investment firm or a discount/online brokerage account during normal trading hours, and usually a commission will be paid for each trade. In contrast, mutual funds are generally purchased from the fund company through a financial intermediary. Transactions are usually processed at the end of each trading day based on the fund’s net asset value (NAV). There is a risk that the value of the mutual fund can change between the time you decide to purchase or sell it and the time at which the end of day NAV is calculated by the mutual fund company.
Because ETFs trade like stocks, investors have the flexibility to use a variety of order types, buy on margin, or sell short. On derivative markets, investors can also buy and sell options on some ETFs. (See ETF Liquidity and Trading)
ETFs generally have two sources of liquidity. One is in the bids and offers displayed in the secondary market where they trade; the second is in the liquidity of the securities comprising the underlying basket. An ETF provider can create or issue and redeem ETF units depending on supply and demand in that secondary market. A designated broker is the authorized market participant who can facilitate this transaction. If, for example, demand for the ETF units exceeds supply, the designated broker can acquire new ETF units from the ETF provider by delivering the securities in the underlying basket and exchanging them for the new ETF units. The broker is in effect accessing that second source of liquidity through new unit issuance. The more liquid the securities in the underlying basket, the more liquid is the ETF itself. Conversely, if supply exceeds demand for ETF units, the broker can accumulate ETF units on the market and redeem them with the ETF provider in exchange for securities in the underlying basket.
Pricing Relative to Net Asset Value
ETFs by design are meant to trade in close proximity to their underlying net asset value (NAV). The structure of ETFs is designed to ensure that the price of the ETF accurately reflects the value of the underlying assets, although in certain market conditions this may not always be the case. The creation/redemption process and arbitrage mechanism ascribed to ETFs are features which reduce the likelihood that ETFs will trade at a premium or discount to their NAV. Whenever there is a discrepancy between the price of the ETF and its underlying NAV, the designated broker will “arbitrage away” the difference through purchases and sales of the ETF and underlying securities until the ETF price is more reflective of the NAV. As an example, let’s say that ETF units are trading at a premium to their NAV because demand exceeds supply. The designated broker will then sell short the more expensive ETF units and buy the less expensive underlying basket of securities. He will have no net exposure to the market since he is fully hedged, and will lock in a profit. At the end of the trading day the broker will exchange that basket with the ETF provider for the equivalent ETF units and close out his position. This arbitrage activity is repeated until the profit incentive is gone and the ETF price is realigned to its NAV. Unlike stocks where there is a finite number of securities outstanding, ETF units can be created and redeemed by the designated broker at the end of each trading day to remedy supply and demand imbalances thereby keeping the market price of the ETF in line with the NAVof its underlying securities.
Like most funds, ETFs have annual fees referred to as management expense ratios (MERs). Because ETFs are typically able to achieve lower operating costs, the fees charged by ETFs are generally lower than those charged by mutual funds, and in most cases certainly far lower than the expense of holding some physical commodities directly. A passive index tracking ETF generally doesn’t require the portfolio manager or analysts to undertake the same level of research as they would for other investment decisions – which can reduce expenses. Further, the fund constituents are reset based on the underlying index and this is often a quarterly event for many indexes, so there is not a lot of rebalancing that involves buying and selling or “turnover” of the securities comprising the underlying basket. This can mean a lower MER. Actively managed and leveraged ETFs will have higher MERs than index ETFs, but these MERs may be lower than those of actively managed mutual funds. Although, at times, the percentage return difference between an ETF and a mutual fund may seem insignificant, the difference over time can substantially affect investment returns. The longer the period during which one is invested and the greater the fee differential - the greater the impact on ultimate returns for investors. The magnitude of cost savings, however, needs to factor in brokerage commissions incurred when buying and selling ETFs.
Passive index tracking ETFs generally have lower turnover of the underlying portfolio, as noted above, than do actively managed funds, thereby triggering less taxable events. But in addition to this, ETFs in general have an “in kind” redemption process which helps to minimize taxes. This is because the “in-kind” redemption avoids the selling of underlying securities whenever investors redeem units of the ETF. When ETF units are redeemed, they are exchanged for other securities in a transaction between the ETF provider and the ETF’s designated broker, thereby avoiding the need for any sale of securities.
Note that some ETFs offer dividends or other distributions on a regular basis; income received from the underlying portfolios flows through to holders of the ETF.
Lower Volatility and Reduced Risk
By virtue of the fact that ETFs are inherently diversified when comprised of multiple securities, their overall price movement will generally depend on the movement of their underlying holdings. Should one or more holdings of the ETF experience price volatility, other holdings in the fund (with less volatility) could moderate the ETF’s overall price movement. For this reason, ETFs may exhibit lower price volatility than individual stocks due to their inherent diversification. This reduced volatility can serve to lower overall portfolio risk for investors.
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Understanding the Risks
When considering an ETF as an investment, as with any other investment vehicle, risk will be involved.
ETF Liquidity and Trading
Investors often assume the daily trading volume of an ETF indicates its liquidity. But that is not necessarily the case.
Creation/Redemption and Arbitrage
ETFs use an "in-kind" creation/redemption process to both create and redeem units, and to response to changes in demand.