Understanding How Do ETFs Work and Their Costs

ETFs are essentially baskets of stocks, bonds, or other securities that track a specific market index or sector. They allow you to own a small piece of a large portfolio with a single investment.

Each ETF holds a basket of securities, and its value is determined by the performance of those securities. For example, an ETF that tracks the S&P 500 index will hold a small portion of each of the 500 companies in the index.

The cost of owning an ETF is relatively low compared to other investment vehicles. In fact, the average expense ratio for an ETF is around 0.2% per year, which means that for every $1,000 you invest, you'll pay $2 in fees.

You can buy and sell ETFs on stock exchanges, just like individual stocks. This makes it easy to get in and out of the market, and to diversify your portfolio by investing in a variety of ETFs.

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An exchange-traded fund, or ETF, is essentially a basket of multiple underlying assets that can be bought and sold on an exchange like an individual stock.

ETFs can be structured to track anything from a commodity to a large and diverse collection of stocks, giving investors a wide range of options.

The first ETF in the U.S. was the SPDR S&P 500 ETF, which tracks the S&P 500 Index and is known as SPY.

ETFs can be designed to track specific investment strategies, making them a versatile tool for investors looking to generate income, speculate, or hedge risk in their portfolio.

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ETFs are registered with the Securities and Exchange Commission (SEC) and are typically set up as open-ended funds, subject to the Investment Company Act of 1940.

Most ETFs have a minimum investment requirement, such as Vanguard's Consumer Staples ETF (VDC), which requires a minimum investment of just $1.00.

A key feature of ETFs is that they don't transfer ownership, instead investors buy a share of the fund, which owns the shares of the underlying companies.

ETF share prices are determined throughout the day, unlike mutual funds which trade only once a day after the markets close.

ETFs limit volatility by diversifying their holdings, making them a popular choice for investors looking to spread their risk.

Authorized participants (APs) act as market makers, purchasing and redeeming ETF shares directly from the ETF issuer in large blocks, called creation units, generally 50,000 shares.

The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism, intended to minimize the potential deviation between the market price and the net asset value of ETF shares.

An ETF must be registered with the Securities and Exchange Commission (SEC) in the United States, and most are set up as open-ended funds subject to the Investment Company Act of 1940.

Most ETFs, like Vanguard's Consumer Staples ETF (VDC), track a specific index, such as the MSCI US Investable Market Consumer Staples 25/50 Index, and hold shares of all the companies on that index.

A few of the companies held by VDC are Proctor & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo.

ETF share prices are determined throughout the day, unlike mutual funds which trade only once a day after the markets close.

This means that ETF prices can fluctuate rapidly in response to changing market conditions.

ETFs are designed to limit volatility by diversifying their holdings, which helps to reduce risk.

Industry ETFs are also used to rotate in and out of sectors during economic cycles.

Authorized participants (APs) can purchase and redeem ETF shares directly from the ETF issuer in large blocks, called creation units, which are generally 50,000 shares.

These purchases and redemptions are usually in kind, with the AP contributing or receiving securities of the same type and proportion held by the ETF.

The lists of ETF holdings are published online, giving investors a clear picture of what they own.

The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism that helps to minimize the potential deviation between the market price and the net asset value of ETF shares.

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If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF issuer and sell the component ETF shares in the open market.

This helps to reduce the market price per share and generally eliminates the premium over net asset value.

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Most Popular ETFs are widely known and used by investors. The oldest and most widely known ETF is the SPDR S&P 500 (SPY), which tracks the S&P 500.

Some ETFs track specific industries, such as the Invesco QQQ (QQQ), also known as "cubes", which tracks the tech-heavy Nasdaq 100 Index. This ETF is popular among tech enthusiasts.

You can also invest in ETFs that track commodities, like gold (GLD) and silver (SLV). These ETFs allow you to invest in precious metals without holding physical gold or silver.

Here are some examples of popular ETFs:

Country ETFs are another type of popular ETF, which track the primary stock indexes in foreign countries. Examples include China (MCHI) and Brazil (EWZ).

Actively Managed ETFs are a type of ETF that uses active management, where the manager executes a specific trading strategy instead of replicating the performance of a stock market index.

The securities held by actively managed ETFs are posted on their websites daily, or quarterly in the cases of active non-transparent ETFs, which can make them vulnerable to front running.

Some actively managed equity ETFs address this problem by trading only weekly or monthly.

The largest actively managed ETFs include the JPMorgan Equity Premium Income ETF, which charges 0.35% in annual fees, and the Pimco Enhanced Short Duration ETF, which charges 0.36% in annual fees.

The JPMorgan Ultra-Short Income ETF charges 0.18% in annual fees, making it a relatively low-cost option among actively managed ETFs.

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Bond ETFs are a type of investment that allows you to diversify your portfolio.

They invest in bonds, which are essentially loans to companies or governments that you can buy into.

Bond ETFs have much more market liquidity than individual bonds, making it easier to buy and sell them.

This means you can get in and out of the market more quickly if you need to.

Bond ETFs are a popular choice for investors because they offer a way to spread risk and potentially earn regular income.

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Currency ETFs offer a way for investors to profit from the foreign exchange spot change, while also receiving local institutional interest rates and a collateral yield.

Investors can choose to invest in or short any major currency or a basket of currencies, giving them flexibility in their investment strategy.

Currency ETFs are issued by reputable companies such as Invesco and Deutsche Bank, among others.

This allows investors to diversify their portfolios and potentially earn returns from changes in currency values.

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Leveraged ETFs can be a powerful tool for investors, but they also come with significant risks.

Leveraged ETFs use derivatives to seek a daily return that corresponds to a multiple of, or the inverse, of an index's daily performance.

For example, Direxion offers leveraged ETFs that attempt to produce 3x the daily result of either investing in or shorting the S&P 500.

Leveraged ETFs effectively increase exposure ahead of a losing session and decrease exposure ahead of a winning session, which is called volatility drag or volatility tax.

This can result in substantial trading losses for the fund manager, who needs to buy when the index goes up and sell when the index goes down to maintain a fixed leverage ratio.

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The first exchange-traded fund (ETF) was the SPDR S&P 500 ETF, launched by State Street Global Advisors on January 22, 1993. This marked a significant milestone in the history of ETFs.

There were some precursors to SPY, including Index Participation Units listed on the Toronto Stock Exchange (TSX), which tracked the Toronto 35 Index and appeared in 1990.

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ETFs offer a range of benefits that make them an attractive option for investors.

ETFs provide exposure to many stocks across various industries, allowing investors to diversify their portfolios with a single investment. This can be especially useful for those who don't have the time or expertise to research and invest in individual stocks.

ETFs have low expense ratios and commissions, which can save investors a significant amount of money in the long run. In fact, some ETFs have expense ratios as low as 0.05%.

One of the biggest drawbacks of ETFs is that actively managed ETFs have higher fees. This can eat into an investor's returns over time, making it harder to achieve their financial goals.

Here are some key benefits and drawbacks of ETFs:

ETFs and index funds are often compared, but they have some key differences. An ETF is more cost-effective and liquid than an index mutual fund.

One significant advantage of ETFs is that they can be bought and sold throughout the trading day, unlike mutual funds which trade once a day at a single price. This flexibility can be beneficial for investors who want to quickly respond to market changes.

Both ETFs and mutual funds represent baskets of individual securities, such as stocks or bonds. This is a fundamental aspect of both investment approaches.

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ETFs offer several benefits, including exposure to many stocks across various industries.

One of the main advantages of ETFs is that they provide low expense ratios and commissions, making them a cost-effective investment option.

ETFs also allow for risk management through diversification, which can help minimize losses in the event of a market downturn.

By focusing on targeted industries or commodities, ETFs can be tailored to specific investment goals.

However, some ETFs have higher fees due to active management.

Single-industry-focused ETFs can also limit diversification, which can increase risk.

In some cases, a lack of liquidity can hinder transactions, making it difficult to buy or sell shares.

ETFs have lower fees than mutual funds, with an industry asset-weighted average OER of 0.16% for passively managed ETFs. This is significantly lower than the fees associated with mutual funds, which can range from 0.02% to 1% of the investment value.

Some brokerages charge commissions for buying or selling ETFs, but with Schwab, listed ETFs that trade on a U.S. exchange are $0 per trade online. This is a significant advantage for investors who want to minimize their costs.

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ETFs do not have loads, which means you won't be charged extra fees when you buy or sell them. In contrast, some mutual funds charge front-end or back-end loads, which can be a significant expense.

The ongoing management fee charged by ETFs can vary widely, but it's often lower than the fees associated with mutual funds. For example, the asset-weighted average OER for cap-weighted Schwab ETFs is just 0.08%.

Here's a comparison of the costs associated with ETFs and mutual funds:

Overall, ETFs are generally cheaper to operate and maintain than mutual funds, which can be a significant advantage for investors who want to minimize their costs.

In the US, ETFs can be more attractive tax-wise than mutual funds for transactions made in taxable accounts. This is because ETF investors generally only realize capital gains when they sell their own shares for a gain.

ETFs offered by Vanguard are actually a different share class of its mutual funds and do not stand on their own. However, they generally do not have any adverse tax issues.

In the United States, ETFs can be more tax-efficient than mutual funds because most buying and selling occur through an exchange. This reduces the need for the ETF sponsor to redeem shares.

In the US, mutual fund shareholders who hold the fund in taxable accounts must pay capital gains taxes on their share of the gain when the fund realizes a capital gain that is not balanced by a realized loss. This is a significant drawback for mutual fund investors.

To invest in ETFs, you can trade through online brokers and traditional broker-dealers. Many online resources provide pre-screened brokers in the ETF industry.

You can also purchase ETFs in your retirement accounts or use a robo-advisor like Betterment and Wealthfront. These alternatives offer a hassle-free way to invest in ETFs.

After creating and funding a brokerage account, you can search for ETFs and buy and sell as you want. One of the best ways to narrow ETF options is to utilize an ETF screening tool with criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.

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ETFs are widely available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, which means you don't have to pay fees to the platform providers to buy or sell ETFs.

Here are some key factors to consider when investing in ETFs:

ETFs can provide diversification, but it's not a guarantee.

Nearly all ETFs offer diversification compared to individual stock purchases, making them a more stable investment option.

However, some ETFs are highly concentrated, holding only a few securities or weighting them heavily.

For example, a fund may have half of its assets invested in just two or three positions, reducing its overall diversification.

This can be a problem if the market performs poorly in the sector where those securities are concentrated.

ETFs can be categorized into several types, each with its own investment strategy and goals.

Passive ETFs aim to replicate the performance of a broader index, such as the S&P 500, while actively managed ETFs allow portfolio managers to make decisions about which securities to buy and sell.

Bond ETFs provide regular income to investors by tracking the performance of underlying bonds, which may include government, corporate, and municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.

Here are some examples of ETF types:

These categories offer a range of investment options for investors to choose from, depending on their goals and risk tolerance.

There are many types of ETFs to choose from, each with its own unique characteristics.

Passive ETFs aim to replicate the performance of a broader index, such as the S&P 500, by holding a basket of securities that track the index.

Actively managed ETFs, on the other hand, have portfolio managers who make decisions about which securities to buy and sell, offering benefits over passive ETFs but charging higher fees.

Bond ETFs provide regular income to investors, distributing dividends based on the performance of underlying bonds.

Industry or sector ETFs offer diversified exposure to a single industry, such as technology or energy, by tracking a specific index.

Commodity ETFs invest in commodities like gold, oil, or agricultural products, and can be structured as exchange-traded grantor trusts, giving investors a direct interest in a fixed portfolio.

Currency ETFs track the performance of currency pairs, allowing investors to speculate on exchange rates or hedge against volatility.

Bitcoin and Ethereum ETFs, approved by the SEC in 2024, expose investors to the price movements of these cryptocurrencies without directly owning them.

Inverse ETFs earn gains from stock declines without shorting stocks, using derivatives to short a stock.

Leveraged ETFs seek to return multiples of the return of the underlying investments, using debt and derivatives to leverage their returns.

Here are some examples of ETF types:

Cryptocurrency ETFs are a type of ETF that invests in cryptocurrencies like Bitcoin and Ethereum. They track the real-time prices of these cryptocurrencies, and their share prices fluctuate accordingly.

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There are two types of crypto ETFs: spot and future-based. Spot crypto ETFs invest directly in cryptocurrencies, while future-based crypto ETFs invest in crypto futures contracts.

Ethereum is gaining significant traction in the cryptocurrency market, particularly in the context of ETFs. For the first time, Ethereum ETFs have surpassed Bitcoin ETFs in daily inflows, with a record $332.9 million on November 29, 2024.

ETF inflows occur when new shares are created due to increased demand, and Ethereum ETFs have seen a historic record of inflows.

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ETFs have a long history, but transparency is a relatively recent development. Issuers are now required to publish the composition of their portfolios daily, or quarterly for active non-transparent ETFs.

This increased transparency is a major advantage for investors, as it allows them to make informed decisions about their investments.

ETFs are also priced continuously throughout the trading day, which means investors can see the current price of an ETF at any given time.

The concept of gold exchange-traded products has been around since 1961, when the Central Fund of Canada was founded.

This closed-end fund was initially designed for ownership of gold and silver bullion, and it's been listed on the Toronto Stock Exchange since 1966 and the American Stock Exchange since 1986.

The first gold exchange-traded fund was launched in 2003 on the Australian Securities Exchange, under the name Gold Bullion Securities.

The idea of a gold ETF was first conceptualized by Benchmark Asset Management Company Private Ltd in India, which filed a proposal with the Securities and Exchange Board of India in May 2002.

The first silver exchange-traded fund, iShares Silver Trust, was launched on the New York Stock Exchange in 2006.

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Issuers are required to publish the composition of their portfolios on their websites daily, or quarterly in the case of active non-transparent ETFs. This is a great way to ensure that investors have access to the information they need to make informed decisions.

ETFs are priced continuously throughout the trading day, which means they offer price transparency. This is a key advantage over traditional mutual funds, which are typically priced once a day after the market closes.