What Are Exchange-Traded Funds (ETFs)?
By David S. Chang
What are Exchange-Traded Funds (ETFs)?
This summary discusses only Exchange-Traded Funds (ETFs) that are registered as open-end investment companies or unit investment trusts under the Investment Company Act of 1940 (the “1940 Act”). It does not address other types of exchange-traded products that are not registered under the 1940 Act, such as exchange-traded commodity funds or exchange-traded notes. The following information is general in nature and is not intended to address the specifics of your financial situation. When considering an investment, make sure you understand the particular investment product fully before making an investment decision.
Exchange-Traded Funds (ETFs) are a type of exchange-traded investment product that must register with the SEC under the 1940 Act as either an open-end investment company (generally known as “funds”) or a unit investment trust.
Like mutual funds, ETFs offer investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets and, in return, to receive an interest in that investment pool. Unlike mutual funds, however, ETF shares are traded on a national stock exchange and at market prices that may or may not be the same as the net asset value (“NAV”) of the shares, that is, the value of the ETF’s assets minus its liabilities divided by the number of shares outstanding.
Things to Consider before Investing in ETFs
ETFs are not mutual funds. Generally, ETFs combine features of a mutual fund, which can be purchased or redeemed at the end of each trading day at its NAV per share, with the intraday trading feature of a closed-end fund, whose shares trade throughout the trading day at market prices.
Unlike with mutual fund shares, retail investors can only purchase and sell ETF shares in market transactions. That is, unlike mutual funds, ETFs do not sell individual shares directly to, or redeem their individual shares directly from, retail investors. Instead, ETF sponsors enter into contractual relationships with one or more financial institutions known as “Authorized Participants.” Authorized Participants typically are large broker-dealers. Only Authorized Participants are permitted to purchase and redeem shares directly from the ETF, and they can do so only in large aggregations or blocks (e.g., 50,000 ETF shares) commonly called “Creation Units.”
Other investors purchase and sell ETF shares in market transactions at market prices. An ETF’s market price typically will be more or less than the fund’s NAV per share. This is because the ETF’s market price fluctuates during the trading day as a result of a variety of factors, including the underlying prices of the ETF’s assets and the demand for the ETF, while the ETF’s NAV is the value of the ETF’s assets minus its liabilities, as calculated by the ETF at the end of each business day.
Types of ETFs
Most ETFs trading in the marketplace are index-based ETFs. These ETFs seek to track a securities index like the S&P 500 stock index and generally invest primarily in the component securities of the index. For example, the SPDR, or “spider” ETF, which seeks to track the S&P 500 stock index, invests in most or all of the equity securities contained in the S&P 500 stock index. Some, but not all, ETFs may post their holdings on their websites on a daily basis.
Actively Managed ETFs
Actively managed ETFs are not based on an index. Instead, they seek to achieve a stated investment objective by investing in a portfolio of stocks, bonds, and other assets. Unlike with an index-based ETF, an adviser of an actively managed ETF may actively buy or sell components in the portfolio on a daily basis without regard to conformity with an index.
Before investing in an ETF, you should read both its summary prospectus and its full prospectus, which provide detailed information on the ETF’s investment objective, principal investment strategies, risks, costs, and historical performance (if any). The SEC’s EDGAR system, as well as Internet search engines, can help you locate a specific ETF prospectus. You can also find prospectuses on the websites of the financial firms that sponsor a particular ETF, as well as through your broker.
Do not invest in something that you do not understand. If you cannot explain the investment opportunity in a few words and in an understandable way, you may need to reconsider the potential investment.
Finally, you may wish to consider seeking the advice of an investment professional. If you do, be sure to work with someone who understands your investment objectives and tolerance for risk. Your investment professional should understand complex products and be able to explain to your satisfaction whether or how they fit with your objectives.
5 Awesome Tips to SMART Productivity
A Step-by-Step Process on How to be More Effective and Efficient at Life!
You must log in to post a comment.