An introduction to Exchange Traded Fund (ETF)

An Exchange-Traded Fund (ETF) is an investment security that combines the features of both mutual funds and stocks. Like mutual funds, ETFs pool money from a group of investors to buy a basket of assets or securities, such as stocks, bonds, or commodities. However, unlike mutual funds, ETFs trade on an exchange, similar to individual stocks.

ETFs are often created to track the performance of a specific index, such as the S&P 500, or a sector or theme, such as technology or renewable energy. This means that when you buy an ETF, you buy a basket of stocks or other assets that comprise that index, sector or theme. As a result, ETFs offer investors a simple and cost-effective way to gain exposure to a diversified portfolio of assets without having to buy individual securities.

ETFs are traded throughout the trading day on stock exchanges, and their prices fluctuate based on the supply and demand of investors. They can be bought and sold through a broker and typically have lower expense ratios and other advantages than traditional mutual funds, making them a popular investment option.

Differences between ETF and mutual fund

There are several differences between ETFs and mutual funds, including:

Trading facility: ETFs trade on an exchange throughout the trading day like a stock, while mutual funds are bought and sold at the end of the trading day at the net asset value (NAV) price.
Trading flexibility: ETFs can be traded using limit and stop orders, sold short, and used in options trading strategies, making them a more flexible investment option for active traders.
Cost: ETFs tend to have lower expense ratios than mutual funds due to lower management costs. ETFs have buy-sell spreads and bid-ask spreads, while mutual funds do not.
Tax efficiency: Liquidation of underlying securities in an ETF or mutual fund can result in capital gains taxes. Therefore, ETFs can be more tax-efficient than mutual funds because they typically have lower trading of underlying securities.
Minimum investment: Mutual funds typically have a minimum initial investment requirement. In contrast, ETFs can be bought and sold for the price of a single unit.
Transparency: ETFs typically publish their holdings daily instead of quarterly, allowing investors to know what securities are held precisely by the ETF daily.

Why is ETF typically cheaper than a mutual fund?

ETFs are typically cheaper than mutual funds tracking the same index for a few reasons, including:

Lower internal trading: ETFs engage in lower internal trading due to how these instruments are designed.
Lower administrative costs: ETFs generally have lower administrative costs, such as record-keeping and reporting, due to lower internal trading.
Tax efficiency: Liquidation of underlying securities in an ETF or mutual fund can result in capital gains taxes. Therefore, ETFs can be more tax-efficient than mutual funds because they typically have lower trading of underlying securities.

These factors contribute to the lower expense ratios typically associated with ETFs. Lower expense ratios mean that investors keep more of their returns, which can significantly impact long-term performance.

Things that ETF can do that a mutual fund cannot do

There are a few things that an ETF can do that a mutual fund cannot do, including:

Trade throughout the day: ETFs trade like individual stocks on an exchange, which means they can be bought and sold during trading hours at market prices. In contrast, mutual funds are priced once a day after the close of the market and can only be bought or sold at that price.
Use limit and stop orders: ETFs can be traded using limit and stop orders, which allows investors to set specific prices at which they want to buy or sell the ETF. Mutual funds do not offer this feature.
Be sold short: ETFs can be sold short, which means that investors can bet on the price of an ETF going down by borrowing and selling units of the ETF. Mutual funds cannot be sold short.
Trade options: ETFs can be used in options trading strategies, which allows investors to use options to bet on the price of an ETF going up or down. Mutual funds cannot be used in options trading strategies.
Use leverage and inverse exposure: Some ETFs use leverage and inverse exposure to amplify returns or bet against the market. Mutual funds generally do not use leverage or inverse exposure.
Create and redeem shares in-kind: ETFs can create and redeem shares in-kind with authorised participants (APs), which are large institutional investors, in exchange for baskets of securities that represent the underlying index or benchmark. This can help keep the ETF’s tracking error low, reduce trading costs, and increase tax efficiency. Mutual funds do not have this ability.
Use custom redemption baskets: ETFs can use custom redemption baskets, which are baskets of securities that differ from the underlying index or benchmark, to redeem shares. This can help the ETF avoid realising capital gains and improve tax efficiency. Mutual funds do not have this ability.

Overall, the trading flexibility and versatility of ETFs compared to mutual funds make them a more suitable investment choice for investors who want to actively trade or use more complex trading strategies.

Things that a mutual fund can do that an ETF cannot do

There are a few things that a mutual fund can do that an ETF cannot do, including:

Offer fractional shares: Mutual funds can offer fractional shares, which allows investors to purchase a specific dollar amount of the fund. With ETFs, investors have to buy whole units unless the broker adds a layer of complexity that allows the investor to purchase fractional units of ETFs through that broker.
Trade at net asset value (NAV): Mutual funds trade at the end-of-day net asset value (NAV), while ETFs trade at market prices throughout the day. This means that investors in mutual funds always know the exact price at which they buy or sell shares, while ETF investors may be subject to bid-ask spreads and other market factors that can affect the price they pay.
More suitable for fund issuer to implement active investment strategies: This is because mutual funds are not subject to the same restrictions as active ETFs when the fund issuer adopts active management strategies for the fund. However, this advantage is diminishing as regulations on active ETFs evolve.
Offer different share classes: Mutual funds can offer different share classes, such as institutional shares or advisor shares, allowing the fund issuer to provide different fee structures and services to different types of investors. ETFs typically only offer one share class.
Use a different structure: Mutual funds can use different structures, such as closed-end funds or unit investment trusts, which can offer different benefits and drawbacks compared to ETFs. Closed-end mutual funds have a fixed number of outstanding shares and trade on an exchange like ETFs but are subject to different regulatory requirements. Closed-end mutual funds can use leverage and may trade at a discount or premium to their NAV.
Offer different redemption procedures: Mutual funds can offer different redemption procedures, such as the ability to redeem shares in-kind, which allows large investors to redeem shares in the form of underlying securities rather than cash. ETFs do not offer this feature.

Comparison of ETFs tracking the same index

When comparing ETFs that track the same index, there are several factors that investors should consider, including:

Expense ratio: The expense ratio is the annual fee charged by the ETF issuer to cover the cost of managing the fund. Investors should compare the expense ratios of the ETFs and choose the one with the lower expense ratio, as this will reduce the drag on investment returns.
Tracking error: Tracking error is the difference between the performance of the ETF and the performance of the index it tracks. A lower tracking error results in a closer alignment of the ETF’s performance with the performance of the underlying index. Investors should compare the tracking errors of the ETFs and choose the one with the lower tracking error.
Holdings: Investors should review the holdings of the ETFs to determine if there are any significant differences in the securities held.
Liquidity: Investors should review the ETF trading volume and ETF bid-ask spreads. Higher trading volume and lower bid-ask spreads are preferable.
Fund size: Investors should review the size of the ETFs, as larger funds tend to have lower expense ratios and higher trading volume, which can result in lower costs and better liquidity. Also, there is a possibility that the ETF issuer terminates an ETF with a small fund size for business reasons.
Tax efficiency: Investors should review the tax efficiency of the ETFs, including any potential capital gains distributions, to determine which ETF will result in the lowest tax liabilities.
Year of fund launch: The older the number of years in operation, the higher the probability that the ETF will stay in business.

It’s important to note that an investor should not consider any single aspect in isolation and that many of the aspects are interdependent, thus impacting the overall investment decision of the investor.

Different types of ETFs

There are different types of ETFs available to investors, including:

Equity ETFs: These invest in a diversified portfolio of stocks, providing exposure to a specific market or sector, such as emerging markets, energy or healthcare.
Bond ETFs: These invest in a diversified portfolio of bonds, providing exposure to different types of fixed income securities, such as investment-grade, high-yield, or municipal bonds.
Commodity ETFs: These invest in a diversified portfolio of physical commodities, such as gold, silver, oil, or agricultural products.
Fixed Income ETFs: These invest in a diversified portfolio of bonds, providing exposure to a specific type of bond, such as corporate bonds, municipal bonds, or treasury bonds.
Currency ETFs: These invest in foreign currencies, providing exposure to the currency markets and potentially providing a hedge against currency risk.
Real Estate ETFs: These invest in a diversified portfolio of real estate assets, providing exposure to the real estate market.
Sector ETFs: These invest in a specific sector of the market, such as energy, healthcare, or financials.
Style ETFs: These invest in a specific investment style, such as value or growth, or in a specific size category, such as small-cap or large-cap.
Thematic ETFs: These invest in a specific theme or trend, such as cyber security, climate change, or cloud computing.
Smart Beta ETFs: These adopt a rules-based approach to select and determine the weight of securities based on various factors such as volatility, momentum, or quality. These ETFs aim to attempt enhanced returns for a given risk, or reduced risk for a given return. The performance of these ETFs is measured against a benchmark.
Leveraged ETFs and leveraged inverse ETFs: These use derivatives and debt to amplify the returns of the index they track.
Active ETFs: These are actively managed by portfolio managers who make investment decisions on behalf of the fund’s investors. The performance of these ETFs is measured against a benchmark.
Ethical ETFs: These invest in companies that meet specific environmental, social, and governance (ESG) criteria, such as sustainable operations and responsible business practices. Ethical ETFs are a type of thematic ETF where the theme is ESG.

There are other types of ETFs too, and new types continue to get developed to meet the evolving needs of investors.

Why is ETF typically more tax efficient than a mutual fund?

ETFs are typically more tax-efficient than mutual funds for a few reasons, including:

Lower internal trading: ETFs engage in lower internal trading due to how these instruments are designed. This results in lower capital gains events that are taxable.
In-kind transactions: ETFs generally use in-kind transactions to create and redeem shares, which can help minimise the realisation of capital gains. This means that instead of selling securities to raise cash, an ETF can swap securities with an authorised participant (AP) who is creating or redeeming ETF shares. This can help the ETF avoid triggering capital gains taxes, unlike mutual funds, which may have to sell securities to meet redemptions.

Please note that this is not tax advice. QuietGrowth does not provide tax advice and is not a registered tax agent. If you have any questions about your tax situation, we recommend you speak with your tax adviser or accountant.

Purchase of ETF units directly from the ETF issuer

Investors can buy and sell ETF shares directly from the ETF issuer through a process known as a creation/redemption process. This process is typically facilitated by an authorised participant (AP), a financial institution that the ETF issuer has authorised to create or redeem shares of the ETF in large blocks.

The investor would provide the AP with a basket of securities that match the composition of the ETF’s underlying index or portfolio. In exchange, the AP would issue the investor a block of ETF shares. The investor could then hold the ETF shares, trade them on an exchange, or redeem them for the underlying basket of securities later.

It’s worth noting that the creation/redemption process is typically used by institutional investors or other large investors, as it can involve significant transaction costs and may require a large amount of capital. Most individual investors buy and sell ETF shares through a brokerage account on a stock exchange, where they can trade shares at market prices like other publicly traded securities.

Disadvantage of bid-ask spread and buy-sell spread to ETF

The bid-ask spread is a cost investors pay while buying or selling ETF units on an exchange. In contrast, the buy-sell spread is a cost investors pay while buying or selling ETF units directly from the issuer, typically facilitated by an authorised participant (AP). While both spreads can affect the trading price of an ETF, they are calculated in different ways and reflect different costs.

The buy-sell spread and bid-ask spread are disadvantages to ETFs compared to mutual funds. However, these spreads can be lesser for ETFs with high trading volumes. Also, for long-term investors not concerned with short-term price fluctuations, these spreads may not be a significant factor in their investment decision.

In contrast, mutual funds are priced based on NAV, so there is no buy-sell spread or bid-ask spread.

Buy-sell spread: The buy-sell spread is the difference between the net asset value (NAV) of an ETF and the price at which investors can buy or sell ETF shares. The NAV is the value of the ETF’s underlying assets, representing the actual value of the ETF’s holdings. The buy-sell spread includes any transaction costs or other expenses associated with buying or selling the ETF, such as brokerage fees or redemption fees. The buy-sell spread can be influenced by factors such as market volatility, trading volume, and the liquidity of the ETF’s underlying assets.

However, because the price of an ETF can fluctuate throughout the trading day based on supply and demand, the market price of the ETF may not always match the NAV of the underlying assets. This means that you may pay more or receive less than the actual value of the ETF’s holdings when you buy or sell the ETF units.

Bid-ask spread: The bid-ask spread is the difference between the highest price a buyer is willing to pay for an ETF (bid price) and the lowest price a seller is willing to accept for an ETF (ask price). The bid-ask spread is determined by market makers, who buy and sell ETF shares on an exchange. The bid-ask spread can vary throughout the trading day and is influenced by factors such as trading volume, liquidity, and market volatility. When you execute a buy or sell trade of an ETF on the exchange, you typically pay a transaction fee and a bid-ask spread.

Steps taken by ETF issuer to reduce the tracking error of their ETF

An ETF issuer can take several steps to minimise the tracking error of their ETF, including:

Optimisation: An ETF issuer may use optimisation techniques to select a subset of securities from the index that closely matches the overall characteristics of the index. This may reduce the tracking error by minimising exposure to securities that are less relevant to the index.
Sampling: Instead of holding all the securities in the index, an ETF issuer may hold a representative sample of the index’s securities. This may reduce the tracking error, as it can be difficult and costly to replicate the exact composition of the index.
Rebalancing: An ETF issuer may rebalance the ETF holdings regularly to ensure they remain aligned with the index. This may reduce the tracking error by minimising the deviation of the ETF’s performance from the index’s performance.
Securities lending: An ETF issuer may lend out the underlying securities in the ETF to other investors in exchange for collateral, such as cash or other securities. This may generate additional income for the ETF, which can be used to reduce the expense ratio and potentially lower the tracking error.
Trading strategies: An ETF issuer may use trading strategies to minimise the tracking error, such as buying or selling securities during specific times of the trading day or using derivatives to manage risk.

Overall, reducing tracking error is an important consideration for ETF issuers, as it can impact the ETF’s performance relative to the underlying index. By using a combination of these techniques, an ETF issuer can work to minimise tracking error and provide investors with a closer alignment of the ETF’s performance with the performance of the underlying index.

History of ETF

The first ETF was launched in 1993 by State Street Global Advisors, called the Standard & Poor’s Depositary Receipt (SPDR) S&P 500 ETF (SPY), which is pronounced as “spider”. The SPDR was designed to track the S&P 500 index and provide investors with a low-cost, liquid way to invest in the US stock market.

The success of the SPY led to the creation of many other ETFs, with the number of ETFs proliferating in the years that followed. By 2000, there were over 100 ETFs available, and that number grew to over 1,000 by 2010. Today, there are thousands of ETFs available covering a wide range of asset classes, sectors, and investment styles.

One reason for the rapid growth of ETFs is their popularity with investors, who appreciate the flexibility, transparency, and low costs of ETFs compared to other types of investment vehicles. ETFs also benefit from the increased availability of electronic trading platforms, making it easy for investors to execute buy and sell trades of ETFs throughout the trading day.

Another factor contributing to the growth of ETFs is the competition among ETF issuers, which has led to the development of new types of ETFs that offer innovative investment strategies and new ways to access different markets and asset classes. The growth of ETFs is mainly at the cost of mutual funds.

Overall, the history of ETFs is one of rapid growth and innovation, driven by the desire of investors to access the markets in a low-cost, flexible, and transparent way.

Our view at QuietGrowth

To know about our view at QuietGrowth regarding ETFs, refer to the ‘Identifying suitable ETFs for each of the asset classes‘ section in our Investment Methodology page.

Related information

Refer to the related knowledge resource:

Difference between Exchange Traded Products (ETP) and Exchange Traded Funds (ETF)

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