What is an ETF? A closer look at how exchange-traded funds work

Simply put, an ETF, or exchange-traded fund, is a basket of securities that trades on an exchange, much like a stock. ETFs are generally highly transparent—their underlying holdings are fully disclosed on a daily basis—and are highly liquid. 

What is an ETF? A closer look at how exchange-traded funds work

But what exactly makes up that basket of securities varies widely. The earliest ETFs invested in stocks and sought to track the performance of broad-based, widely followed indexes such as the S&P 500 Index. Today, ETFs invest not only in stocks, but also in bonds, commodities, and currencies; some more exotic ETFs seek to track market metrics such as interest rates or volatility. This diversity and flexibility have helped make ETFs into one of the fastest-growing segments of the investment universe. 

The ETF market has grown dramatically in the past decade

The difference between an ETF and a mutual fund

The main difference between an ETF and a mutual fund lies in how each is priced and traded. Buy and sell orders for mutual funds are processed after exchanges close at the end of the day. The value of all of the holdings in a mutual fund’s portfolio are then repriced and the fund’s share price is recalculated; that figure is called a fund’s net asset value (NAV), and buy and sell orders are processed based on that figure.

The NAV for ETFs, on the other hand, are calculated throughout the day, and shares in an ETF can be bought or sold at any time during normal trading hours. Typically, for every buyer of an ETF share, there’s a corresponding seller, just like with a stock. But if demand jumps or drops off significantly, there are mechanisms in place to either create new shares or retire existing ETF shares; this process helps ensure that the price of an ETF reflects the underlying value of the securities in its portfolio (which is how mutual funds trade) and not the level of demand among investors (which is how stocks trade).

Why ETFs are so cheap: the built-in benefits of passive management

In the United States, nearly two-thirds of all investment dollars today are in actively managed strategies1 (portfolios managed by teams of investment professionals with the goal of outperforming a benchmark index), but ETFs are a different story. Most ETFs—and the vast majority of ETF assets—are invested in passively managed strategies, which seek to track, rather than beat, the performance of a benchmark index, whether that index is the S&P 500 Index or the price of gold.

That’s one of the reasons ETFs tend to be relatively inexpensive. Once the benchmark index—in essence, an ETF’s blueprint—has been established, passive ETFs don’t need to finance research, management, and trading operations in order to function; actively managed strategies on the other hand, do.

That said, there’s no inherent reason why passive ETFs have to track garden-variety indexes. In fact, one of the newer trends among ETF providers has been to develop more targeted, outcome-oriented indexes; for example, indexes made up only of dividend-paying stocks or stocks that demonstrate low volatility. The sophistication of an ETF’s underlying index is limited only by the imagination of its creators. 

How to incorporate ETFs into a portfolio

While there is no one right way to use ETFs, one popular approach is to use passive ETFs to gain broad exposure to particular markets and use actively managed mutual funds to seek to add value in other, more nuanced areas. Regardless of how it’s done, taking a purely active or purely passive approach is increasingly becoming the exception rather than the rule. In fact, according to a recent survey, 77% of financial advisors recommended a blend of active and passive approaches for their clients’ portfolios.2

To see what role ETFs might play in your portfolio, talk to your financial advisor, and to learn more about some of the unique strategies ETFs can help you pursue, explore our page on ETF investing

 

1 Morningstar, as of 8/22/18.
2 “2017 Trends in Investing Survey,“ Financial Planning Association, Research and Practice Institute, Journal of Financial Planning, 2017.