Exchange-traded funds were introduced in the early 1990s in Canada and the US, and in Europe in 2000. They have experienced impressive growth due to their attractive features, relatively low costs, transparent structure, and thanks to the fact that they offer a range of exposures. But since the ETF space has expanded so much, it is sometimes difficult to make a choice, especially if one does not have sufficient experience or does not know what to focus on.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

how do exchange-traded funds work?

An ETF is a type of investment fund that trades like a stock on an exchange. Since it can be continuously bought and sold when the market is open during the trading day, it has a stock-like appeal that is very attractive to individual long-term investors and shorter-term traders. ETF shares are created or redeemed in kind, in a shares-for-shares swap.¹

There are two linked markets in which ETF transactions happen²:
1) between the ETF issuer/provider and authorized participants (APs), i.e., special institutional investors, in an over-the-counter (OTC) primary market; and
2) between end-investors and brokers on exchanges, i.e., the secondary market.

The stylized structure of these transactions looks like the figure below³: the AP purchases the underlying securities and then exchanges them for an equal-valued block of ETF shares (i.e., an in-kind swap) called a creation unit or basket. The AP sells the ETF shares to investors or market-makers, who then can sell them to brokers and end-investors in the secondary market. The AP can also redeem ETF shares when the process runs in reverse, by buying enough ETF shares to form a creation unit and exchanging it for the same value of underlying securities, which effectively removes the ETF shares from the market. The ETF provider publishes a list of required in-kind securities on a daily basis – for example, an S&P 500 index ETF requires a list of the constituent index stocks in quantities that reflect their corresponding weights in the index itself. This stock basket is also the portfolio that helps determine the net asset value of the ETF using the corresponding day’s prices. The creation and redemption operations take place after the markets close, but the AP is able to execute ETF trades throughout the trading day because they know the composition of the basket needed. As long as the stocks in the basket are fairly priced, the AP should have no economic exposure in these transactions – after all, the exchange is identical – the value of the basket is equal to the value of the ETF share block.

The creation and redemption mechanism just described should help maintain the price of an ETF very close to the net asset value (NAV) of the portfolio of underlying securities. When the security basket has a value different from the ETF shares it represents, the AP can take advantage of an arbitrage opportunity, i.e. profit without risk from the difference. The authorized participants would generally monitor whether price and condition developments cause such discrepancies and be ready to step in if the opportunity presents itself.

The individual investor therefore interacts with this world via their brokerage account, as the broker can acquire and dispose of ETFs as ordered in the secondary market, similar to how one would create buy and sell orders for an individual publicly traded stock.

comparison to Mutual funds

The closest comparison of ETFs is to mutual funds. Mutual funds can also track certain baskets of stocks or indices, but mutual funds must be purchased or sold at the end of the day from the fund manager or via a broker, at the close-of-day NAV of the fund’s holdings, in a cash-for-shares or shares-for-cash swap. They do not trade during the trading day and are therefore not continuously priced. This also means that when the number of purchases is larger and the size of the purchases smaller (e.g., when dollar-cost averaging), ETFs could be more costly than low-cost open-ended index mutual funds due to the per-purchase commissions that may apply. However, large purchases with the intention to hold for long periods are where ETFs are appropriate. There are providers where ETFs are also offered and traded commission-free, thereby eliminating such problems.

Because of how the creation and redemption process works, the AP absorbs all securities transaction costs for the fund portfolio and passes them onto investors in the ETF bid-ask spread. Thus, non-transacting shareholders of an ETF are protected from transaction costs of other investors exiting and entering the fund. For mutual funds, however, when investors enter or exit, the mutual fund manager will incur costs for buying and selling securities due to this activity – thereby, affecting all fund shareholders. So with ETFs, frequent traders will effectively bear the cost of their activity while those who just buy and hold won’t incur those costs.

ETF providers are not involved in tracking individual investor accounts and generally do not communicate with individual investors directly, unlike mutual funds – hence, they can afford to charge lower fees. ETFs also generally distribute less in capital gains than competing mutual funds, making them more tax efficient.

The difference in intraday trading and pricing means that ETFs are also more liquid. In addition, differences in disclosure frequency imply that ETFs have more transparency – holdings are made known on a regular basis, while mutual funds are required to disclose their holding only on quarter-ends with 30-day lags.

ETF BEnefits for individual investors

There are good reasons why ETFs are such popular investment products – they offer a lot of advantages to investors and that makes them useful and accessible wealth-building vehicles. Among the most important benefits, as already mentioned above, are the low costs, better liquidity compared to other funds, and better tax efficiency. But it goes beyond that.

1. Diversification – With ETFs, you do not limit your exposure to an individual stock, which means you have an efficient and quick way to obtain an entire portfolio without having to trade each individual component stock. To avoid concentrating your exposure to a specific sector or group of shares with specific factor exposures, you could also diversify more by picking ETFs tracking broader market indices. You can also pick ETFs covering various asset classes or regions/currencies, which enables you to obtain international diversification.

2. Access to various strategies and exposures – ETFs have such variety that they can be used for the implementation of a wide range of investing strategies, and flexible adjustment of the strategic and tactical asset allocation of investors depending on market conditions and changing outlooks. ETFs can be used to invest excess cash balances quickly, enabling investors to stay fully invested in a target exposure, minimizing cash drag, or they can be utilized to fill temporary exposure gaps to asset classes, industries, or risk factors. Apart from stock exposures, ETFs also offer the possibility to get fixed-income index exposures in a much lower-cost way than just investing in individual bonds. Similarly, you can obtain international or commodity exposures. In addition to that, if broad indices are not suitable or the desired exposure is only to specific sectors – you have ETFs covering only tech, financials, healthcare companies, etc.

3. Factors – One of the most significant advantages of ETFs today is that you can fine-tune your exposure to risk factors. For instance, there are ETFs covering value, growth, momentum, low volatility, and various size factors for equities. You can also more specifically select fixed-income exposures, such as investment-grade corporate vs. high-yield corporate bonds. These are also called smart beta ETFs because the calibration of the exposure weights is done via the factor sensitivities measured by the so-called beta coefficients. Plus, ETF providers offer competing products in a lot of those factor categories, differentiated by various criteria, so the space is not limited to just one choice. There are also multi-factor ETFs that might provide dynamic weight adjustment when risks and market conditions evolve.

4. Easier risk management – Because of their diversity and the possibility of selecting more narrowly one’s exposures, ETFs can be very useful in controlling and managing risks in personal investment portfolios over time. In addition, low-volatility factor ETFs are constructed on the basis of reduced relative return volatility. Some ETFs can enable a more accessible way to adjust currency, interest rate, and duration risks.

risks to keep in mind

While ETFs are very much preferred products by many individual investors to gain exposure to both the wider market and to specific segments of it or specific factors, they do come with additional risks that need to be factored in when making investment decisions. If investors do not keep track of those and understand their nature, they might take on more risk than they’re able to tolerate and expose themselves in ways they might not have foreseen.

1. Spread widening – Bid-ask spreads of ETF can expand materially under stress market conditions, which can make transacting in those ETFs more costly for investors. Factors that can cause this include the costs of arbitrage (buying the underlying securities vs. selling the ETF), and the risk premium in compensation for volatility and liquidity risks (securities and ETF volume).

2. Premiums and discounts – One key component of the ETF ownership cost is the difference between the exchange prices of the ETF and the fund’s NAV calculated based on the prices of underlying securities weighted by the portfolio positions at the start of each trading day. NAVs capture the last traded prices and are only known with a time lag to the ETF price. As a result, investors could end up paying more for an ETF than the value of its underlying stocks (a premium), or they may have to sell an ETF for less than the value of its holdings (a discount).

3. Market volatility – Rapid increase in market fluctuations can affect both what we mentioned in points 1 and 2 – i.e., the bid-ask spreads can widen significantly, while the premiums and discounts to NAV increase. Hence, volatility can contribute materially to an increase in the costs for investors.

4. Leverage, use of derivatives, and shorting – There are ETFs out there that offer levered, inverse or both levered and inverse exposure to a given portfolio or index, meaning that they have a daily performance objective that is a multiple of index returns and that the must reset or adjust their exposure daily to deliver the target return multiple each day. For instance, a fund that provides 300% exposure to the S&P 500 index and has an NAV of $100 could be utilizing swaps to obtain a notional exposure of $300. If the one-day index return is 5%, the $300 in exposure turns into $315, while the ETF end-of-day NAV becomes $115 ($100 x [1 + 3×5%]). As with any levered product, leverage amplifies both profits and losses, hence they are generally riskier as they experience more significant moves. This also has a consequence for rebalancing one’s allocation to return to the target. Meanwhile, inverse ETFs are intended to profit from a fall in the value of the underlying portfolio or index by using derivatives of different kinds, effectively achieving a sort of short position. This can be achieved by using futures contracts to ensure that the ETF will rise in value by the same percentage as the index has fallen. These types of ETFs usually have higher fees and cannot be held for a long time and carry the risk of quickly accumulating losses when the market does not move as expected. They can also be combined with leverage (double or triple inverse), which compounds those risks.

5. Financial system risks – Due to the strong growth of ETFs in the last several decades, they could potentially present increased systemic risks for financial stability. As central banks note, institutional investors are increasingly relying on ETFs for liquidity management purposes, which might imply that investors are becoming more sensitive to a materialization of liquidity risk.  The reliance on algorithms as well as the fast pace at which trading is executed, raise the potential impact of operational risk. Moreover, some research finds that high-frequency traders provide liquidity in normal times while consuming liquidity in stressed times. Large redemptions as a response to increased counterparty risk (for example, during market downturns) would lead to forced selling of collateral securities by the ETF and may put further downward pressure on already falling asset prices, creating a negative feedback loop.

6. Potential liquidity frictions – ETFs can enable the transformation of less liquid assets into more liquid tradable securities, and through the involvement of multiple participants on the primary, secondary, and linked hedging markets, contribute to a high degree of market liquidity. But if market conditions deteriorate rapidly and unexpectedly, there could be significant disruptions to liquidity due to extreme volatility, sharp increases in the costs for market participants, operational glitches with market-makers, etc., with a possible negative feedback loop from increased redemptions.

7. Counterparty risk – ETF structures that are created to provide exposure to alternative asset classes or less conventional investment strategies, may carry counterparty risk – hence, understanding this in advance is essential.

9. Complexities – Some ETFs are designed in ways that are more complex in order to implement specific strategies, making them more difficult for the non-professional investor to properly understand the dynamics and driving forces. The design features, risks and benefits, and the corresponding performance impacts must be well understood and evaluated against one’s risk capacity and financial goals, limitations, and circumstances, before investing in them.

10. Exchange-Traded Notes (ETNs) – These have a creation and redemption process and trade on exchanges similar to ETFs, but they are not funds, but rather unsecured debt obligations of their issuer (usually a large bank or a financial institution), and hold no underlying securities. They promise to pay some returns based on an index minus expenses, plus return the principal at maturity, and the issuer sets up hedges so that they can ensure obligations are met. The potential counterparty risk of ETNs is the most significant relative to all exchange-traded products precisely because they are unsecured, unsubordinated debt notes subject to issuer default. There is also no board overseeing investment management decisions like with ETFs, but rather management based entirely on the prospectus rules and pricing supplements. Some ETNs have very low liquidity due to low trading activity, and can therefore have quite wide bid-ask spreads. The potential for supply-demand mismatch impacting the market price of an ETN (and causing it to deviate significantly from the indicative underlying value) is much higher because the supply of shares outstanding is determined entirely by the issuing institution which must take on additional debt every time they create new units, and not simply in response to investor demand like with ETFs. The ETN closure process can also bring additional risks for investors.

how to choose from the wide ETF universe?

In the graph below you will find several key criteria you could look at when evaluating and making a choice which ETFs you could add to your portfolio. Screening software could be helpful in answering some of those questions, but in general, it is better, if you don’t have sufficient experience, to make these assessments with the help of a financial planner or an investment advisor.

Individual investors should remember that evaluating the structure and exposure theme, risk-return profile, and expenses are the most important steps in deciding whether a given ETF fits in one’s portfolio and with one’s financial goals, risk tolerance, and circumstances. Some ETFs are actively managed and have much higher costs. Others may have strategies or construction methodologies that are unsuitable for you. And some may offer exposures to sectors of the economy or other countries and currencies that may expose you to unwanted risks. Ignoring any of that could lead to a costly mistake.

conclusion

Exchange-traded funds are popular for offering low-cost diversified exposures to broad market indices, industries, and factors, in a generally easy-to-understand, transparent ‘package’. This is not always the case though – and knowing what you are getting, how and what risks there are – is critical in evaluating whether you are making the right decision.

References

1. Hill, J., Nadig, D., Exchange-Traded Funds: Mechanics and Applications, CFA Institute ↩︎
2. Central Bank of Ireland, 2017, Exchange Traded Funds – Discussion Paper ↩︎
3. Grill, M. et. al., 2018, Counterparty and liquidity risks in exchange-traded funds ↩︎