What is an ETF?

You may have heard of the media hype over ETFs but may or may not know what they stand for or what role ETFs can play in your portfolio.

Well, today, we look into what these products are about and why we as investors should care.

ETFs stand for Exchange Traded Funds (ETF) and the first ETF in the United States was created by State Street Global Advisors in 1993 to track the S&P 500.

ETFs Track Indices

So the first key feature of an ETF is that it’s a type of financial product that tracks an index.

What’s an index, you ask?

An index is just a collection of securities: stocks or bonds and is rules based. For a stock index, the rules define which stocks can be included in the index and how much of each stock should be included i.e. the weight of each stock.

For example, S&P 500 is a stock market index that has stocks of 500 public companies. The weight of each stock in the index equals its market capitalization ( market capitalization = shares outstanding x price). The bigger the company, the more weight or influence it has in the index.

Now let’s come back to the ETFs. One ETF that tracks the S&P 500 index has ticker SPY. This ETF owns all the stocks listed in the S&P 500 Index and in the exact proportions specified by the index.

ETFs Are Transparent

Since an ETF tracks an index, you or I can easily check what is included in the index the ETF is tracking. Therefore, we know what’s in the ETF. That makes an ETF transparent.

On the other hand, consider for example a mutual fund where the portfolio manager decides which stocks to include and only reveals what’s included in the mutual fund at the end of the quarter when the fund manager is required by law to share the results and what the manager owns.

Let’s continue with the example of SPY. If you want to know which stocks are included in SPY, you could visit State Street Global Advisor site and see the holdings. I have included a partial snapshot from their site:

Top holdings of SPY ETF

ETFs Are Tax Efficient

ETFs are also tax efficient when compared to mutual funds. This is more relevant when you invest in an ETF or a mutual fund in a taxable account.

There are 2 key reasons why ETFs are more tax efficient than mutual funds:

  • Low turnover
  • In-kind redemption

Low Turnover

Since ETFs track an index and the index doesn't change often, ETFs don't buy or sell (also called turnover) that often when compared to a mutual fund. As a result, you are not hit by taxable capital gains as often as you would with a mutual fund.

Mutual funds generally have high turnover. In a mutual fund, the portfolio manager may buy and sell often to try and outperform the market. Therefore, you, as an investor, get hit by taxable capital gains distributions and if you hold the fund in a taxable account, you have to pay the tax.

In-kind REDEMPTION

ETFs follow a process known as “in-kind” redemption which basically means that retail investors don’t get hit by capital gains distributions when new shares are created or destroyed. You sell your ETF just like you would a stock and pay tax on any gain you may have when you sell the ETF.

That’s not the case with mutual funds where fund managers issue capital gains distributions for a variety of reasons. And if you hold the mutual fund in a taxable account, you may pay tax even if you don’t sell the fund shares.

For example, say several investors want out of a mutual fund where you are an investor. These investors sell their shares to the mutual fund company which reduces the share count and returns cash. But, in order to come up with the cash, the portfolio manager of the fund generally has to sell appreciated stock to pay those investors who want out. Any capital gains is then distributed among the remaining investors like you who, unfortunately, have to pay tax on this distribution.

ETFs Offer Diversification At Low Cost

Low Expense Ratios

The other cool benefit of ETFs is the benefit of diversification at a low cost. Since ETFs track an index which is a collection of many stocks, you can spread your wealth in many stocks just by investing in an ETF.

And the beauty is that you can achieve this diversification at a very low cost. How is that possible you may wonder?

Because unlike actively managed mutual funds where you foot the bill for a portfolio manager and a staff of researchers trying to figure out which stocks to hold in the mutual fund, ETFs are passive and have no such costs.

ETFs own what the index they are tracking owns and these index-linked ETFs have much lower expenses as a result. So you as an investor benefit because less of your money goes into paying fees and grows over time. Low fees can have significant impact on your returns long term.

Check out the low fees of SPY

SPY quote from Morningstar, showing expense ratio

At this point, you may ask: what if the actively managed funds outperform? Such funds may have high fees but surely the portfolio manager and the staff will pick stocks that can outperform so investors may come out ahead. Well, here is the rub.

Many studies show most portfolio managers can’t outperform once fees are taken into account and increasingly investors are looking to low fee ETFs to create diversified portfolios.

Check out how investors have directed their money towards ETFs over time.

Growth in number and total investments in ETFs
Source: http://www.icifactbook.org/ch3/17_fb_ch3#demand

What Does It Cost To Buy An ETF?

Nothing is free in life and neither is buying ETFs. You do incur costs when you invest in an ETF.

Commission

Since an ETF trades like a stock, when you buy an ETF through your discount broker, you pay a commission. For example, Fidelity shows I would pay $4.95 if I buy 10 shares of SPY.

Order ticket for an ETF trade

 

Bid-ask spreads

The other type of cost that you incur with ETFs is the bid-ask spread. Basically, you as an investor buy at the ask and sell at the bid price. The ask is the lowest price at which someone is willing to sell the shares and bid is the highest price at which someone is willing to buy your shares from you.

Generally, the ask price is higher than the bid price and the difference for you as an investor is the transaction cost.

If the ETF does not have a lot of liquidity, meaning the daily trading volume is low, bid-ask spread is wide. For an ETF like SPY the average volume is 64M so you won’t have any trouble buying or selling a few thousand shares of SPY if you wanted.

Check out the bid-ask spread for SPY from Yahoo Finance:

Quote for SPY from Yahoo Finance

If you want to buy a share of SPY, you can do at the ask price of $246.7. Now if you turn around and immediately sell, someone can buy from you at the bid price of $246.67. The $0.03 spread is the loss you incur in addition to brokerage commissions.

The bid-ask spread depends on the liquidity of the ETF. If a lot of shares are traded during the day, the bid-ask is narrow but if few shares are traded, you will not find a lot of sellers or buyers.

For example, check out the bid-ask spread for a less liquid ETF, ticker: ICF from Yahoo Finance.

Quote for ICF ETF from Yahoo Finance, showing bid/ask spread

 

You can buy shares of ICF at $104 but you can only sell those shares at $96.96. The $4.04 spread is your cost of investing in ICF. Also check out the low average volume of 133,925 compared to the 64M for SPY.

How Do You Buy an ETF?

ETFs trade on an exchange just like stocks. What that means is, if you have an account with a discount brokerage like Fidelity or Schwab, you can buy an ETF using its ticker, just as you would when buying a stock.

And the ETF price changes during trading hours similar to a stock. Now that’s a huge advantage compared to a mutual fund. Why you wonder?

When you own a mutual fund and you decide to sell your shares, say in the morning and place a sell order, the price you get for your shares is determined at the end of the trading day based on your mutual fund’s net asset value (NAV). So if the market drops after you place the sell order and closes negative for the day, you get a low price for your fund shares as reflected by the fund’s NAV.

Not the case with ETFs!

If you decide to sell your shares in an ETF in the morning, you can sell them at the price at which ETFs are trading at that moment just like you would when selling a stock.

And just as with stocks, you can buy your ETF on margin and trade options on your ETFs but let’s leave option trading for another day.

Check out our take on whether mutual funds or ETFs are right for you.