Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) have become one of the fastest-growing investment products. They combine features of mutual funds and stocks, offering diversification with the flexibility of intraday trading. Understanding how ETFs differ from mutual funds is key for the SIE exam.
What Is an ETF?
An exchange-traded fund (ETF) is a pooled investment that trades on stock exchanges throughout the day, like individual stocks.
Key Features
| Feature | ETFs |
|---|---|
| Trading | Intraday on exchanges |
| Pricing | Market price (fluctuates continuously) |
| Management | Usually passive (tracks an index) |
| Minimum investment | One share |
| Transparency | Holdings typically disclosed daily |
ETFs vs. Mutual Funds
| Factor | ETFs | Mutual Funds |
|---|---|---|
| Trading | Throughout the day | Once daily (at 4 PM NAV) |
| Pricing | Real-time market price | End-of-day NAV |
| Order types | Market, limit, stop orders | Market orders only |
| Short selling | Yes | No |
| Minimum investment | Price of 1 share | Often $1,000-$3,000 |
| Management style | Usually passive | Active or passive |
| Expense ratios | Generally lower | Generally higher |
| Tax efficiency | More efficient | Less efficient |
How ETFs Trade
ETFs trade like stocks on exchanges:
- Market orders: Execute immediately at current price
- Limit orders: Execute only at specified price or better
- Stop orders: Trigger when price reaches specified level
- Intraday trading: Buy and sell multiple times per day
Key Difference: Mutual fund orders execute at end-of-day NAV regardless of when placed. ETF orders execute immediately at current market price.
ETF Pricing
ETFs have two prices:
| Price | Description |
|---|---|
| Market price | What you pay/receive when trading |
| NAV | Value of underlying holdings per share |
Market price usually stays close to NAV, but can differ slightly:
- Premium: Market price > NAV
- Discount: Market price < NAV
The Creation/Redemption Process
ETFs have a unique mechanism that keeps prices aligned with NAV:
Authorized Participants (APs)
Large institutional investors called authorized participants can:
- Create ETF shares by delivering underlying securities to the fund
- Redeem ETF shares by exchanging them for underlying securities
How It Works
| Situation | AP Action | Result |
|---|---|---|
| ETF trades at premium | AP creates new shares | Supply increases, price falls toward NAV |
| ETF trades at discount | AP redeems shares | Supply decreases, price rises toward NAV |
This arbitrage process keeps ETF prices close to NAV.
Tax Efficiency
ETFs are generally more tax-efficient than mutual funds due to:
In-Kind Redemptions
When APs redeem shares, they receive underlying securities (not cash). This means:
- Fund does not need to sell securities
- No taxable capital gains triggered
- Existing shareholders avoid unexpected tax bills
Mutual Fund Capital Gains Problem
Mutual funds must sell securities to meet redemptions, potentially triggering capital gains that are distributed to all shareholders—even those who did not sell.
Tax Advantage: ETF investors typically only realize capital gains when they sell their own shares, not from other investors' activity.
Types of ETFs
| Type | Description | Example |
|---|---|---|
| Index ETFs | Track market indexes | S&P 500, Russell 2000 |
| Sector ETFs | Focus on specific industries | Technology, healthcare |
| Bond ETFs | Hold fixed-income securities | Treasury, corporate bonds |
| Commodity ETFs | Track commodities | Gold, oil |
| International ETFs | Invest in foreign markets | Emerging markets, Europe |
| Actively managed ETFs | Portfolio manager makes decisions | Growing category |
Advantages of ETFs
| Advantage | Description |
|---|---|
| Lower costs | Typically lower expense ratios than mutual funds |
| Trading flexibility | Buy/sell anytime during market hours |
| Tax efficiency | Fewer taxable distributions |
| Transparency | Holdings disclosed daily |
| No minimum investment | Buy as little as one share |
| Diversification | Single trade provides broad exposure |
Disadvantages of ETFs
| Disadvantage | Description |
|---|---|
| Trading costs | Brokerage commissions (though many are now free) |
| Bid-ask spread | Cost embedded in price difference |
| Premium/discount | May not trade exactly at NAV |
| Overtrading temptation | Easy access can encourage excessive trading |
| Less suitable for dollar-cost averaging | Mutual funds handle fractional shares better |
Key ETF Terminology
| Term | Definition |
|---|---|
| Authorized participant | Institution that can create/redeem ETF shares |
| Creation unit | Large block of ETF shares (typically 25,000-50,000) |
| In-kind transfer | Exchange of ETF shares for underlying securities |
| Indicative NAV (iNAV) | Estimated NAV updated throughout trading day |
Key Takeaways
- ETFs trade on exchanges throughout the day at market prices
- Mutual funds trade once daily at end-of-day NAV
- ETF creation/redemption process keeps prices close to NAV
- ETFs are generally more tax-efficient than mutual funds
- Most ETFs are passively managed with lower expense ratios
- ETFs offer trading flexibility: limit orders, stop orders, short selling
An investor places an order to purchase an ETF at 2:00 PM. When will the order execute and at what price?
ETFs are generally more tax-efficient than mutual funds primarily because of:
Which of the following can an investor do with ETFs but NOT with open-end mutual funds?
2.16 UITs & REITs
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