Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) combine features of mutual funds and individual stocks. They hold a portfolio of securities but trade on exchanges throughout the day like stocks.

What is an ETF?

An ETF is an investment fund that:

• Holds a basket of securities (stocks, bonds, commodities, etc.)
• Trades on stock exchanges throughout the day
• Has real-time pricing (not end-of-day like mutual funds)
• Can be bought and sold at market prices
• Typically tracks an index (most are passively managed)

ETF vs. Mutual Fund Comparison

Key Advantages of ETFs

1. Intraday Trading

Unlike mutual funds, ETFs can be:

• Bought and sold throughout the trading day
• Purchased using limit orders, stop orders, etc.
• Sold short
• Purchased on margin

2. Lower Expense Ratios

Most ETFs are passively managed (tracking an index), resulting in:

• Lower management costs
• Average ETF expense ratio: ~0.20%
• Average mutual fund expense ratio: ~0.50-1.00%

3. Tax Efficiency

ETFs are generally more tax-efficient because:

• The creation/redemption mechanism minimizes capital gains distributions
• Lower portfolio turnover (for index ETFs)
• Investors control when they realize gains (by choosing when to sell)

4. Transparency

Most ETFs disclose holdings daily, while mutual funds typically disclose quarterly.

Creation/Redemption Mechanism

ETFs use Authorized Participants (APs) to create and redeem shares:

Creation Process

1. AP delivers basket of securities to ETF
2. ETF issues new ETF shares to AP
3. AP sells shares on exchange

Redemption Process

1. AP buys ETF shares on exchange
2. AP delivers shares to ETF
3. ETF delivers basket of securities to AP

This "in-kind" process:

• Keeps ETF price close to NAV
• Avoids selling securities (and triggering capital gains)
• Makes ETFs more tax-efficient

Types of ETFs

Leveraged and Inverse ETFs

Leveraged ETFs

Leveraged ETFs use derivatives to amplify returns:

• 2x or 3x the daily return of an index
• Example: 2x S&P 500 ETF aims for 2% gain when S&P gains 1%
• High risk — Losses also magnified
• Reset daily — Not suitable for long-term holding

Inverse ETFs

Inverse ETFs move opposite to the underlying index:

• Profit when markets decline
• Used for hedging or bearish bets
• Also reset daily

Warning: Leveraged and inverse ETFs are complex products with significant risks. Due to daily rebalancing, returns over longer periods may differ significantly from the expected multiple.

ETF Considerations

Potential Disadvantages

Suitability Considerations

ETFs may be suitable for:

• Cost-conscious investors (low expenses)
• Tax-sensitive investors (tax efficiency)
• Active traders (intraday liquidity)
• Investors wanting specific market exposure

Exam Tip: Remember that ETFs trade like stocks (intraday, on exchanges) but hold diversified portfolios like mutual funds. The key differentiator is trading flexibility and typically lower costs.