Exchange traded funds (ETF) are designed to accommodate a lot of people. They can be complicated, even though many are designed to accomplish pretty simple investment objectives. ETFs can be structured to deliver just about any desired investment outcome you can think of. That makes them very versatile investment vehicles.
Touching on the Surface of the ETF
An ETF is a professionally managed investment portfolio. The investors in it are typically individuals, maybe like you.
The money you and other people invest gets pooled together to buy a bunch of securities that help the portfolio accomplish its stated investment objective. That portfolio is the underlying asset and the shares of the fund you own represent your fraction interest in it. And your ownership interest is represented by shares, not unlike what a public company issues to investors.
Notably, just like shareholders of a public company, fund investors can buy or sell (trade) their interest on an open exchange, like the NYSE or NASDAQ. This is how the ETF gets its name.
What’s Beneath the Surface of the ETF?
When you’re swimming at home, you can jump in and pop out of the pool any time you want. Heck, in the hot summer, you could do that all day long. There’s an ETF analogy here. Because they’re traded on an exchange, some ETFs offer similar liquidity to common stocks. Most are easy to buy and sell.1
When you do, there’s another investor on the opposite end of those transactions. The fund itself isn’t involved in this trading activity. Since the manager isn’t redeeming shares, the underlying portfolio remains intact. Share redemptions don’t create unintended capital gains for the fund, which would be passed on to investors. This is part of what helps make ETFs tax efficient.
Since the fund manager isn’t constantly tinkering with the portfolio to satisfy share redemptions, it can also avoid the extra expense that sort of activity generates. That’s one reason ETF fees are typically modest.
A Deeper Dive Into the ETF
When you buy or sell an ETF, results of those transactions are known within minutes. But that doesn’t mean they’ll always be at Net Asset Value (NAV). The market determines price. So, you could pay more (or be paid less) than the fund’s underlying investments are worth. But that risk is typically low.
The market for ETFs is very transparent. ETFs report real-time estimates of their NAVs to quote services used by large institutional traders three or four times every minute. This helps professional market makers or traders instantly dive in to buy or sell even the tiniest price discrepancy between market price and NAV.
This activity helps keep NAV and market price typically pretty close to one another. And that can be beneficial for everyday investors looking to own fund shares.
Now, while ETFs are generally tax efficient, they can still pass on capital gains, dividends, and other taxable income to shareholders. But this is typically the result of intended portfolio decisions, not because redemptions force the investment manager’s hand.
Even though ETF fees can be modest, you still may have to pay a brokerage commission whenever you buy or sell one. And, of course, those transactions could lead to taxable gains or losses for you.
Diving Board vs. Diving Platform
There’s a huge difference between a 33-foot diving platform and the springboard of a backyard pool. One’s a little scarier than the other. This may be said of ETFs too.
There’s an ETF for just about any investor, from the totally fearless to the completely risk averse. Some ETFs concentrate on specific asset classes, like stocks or bonds. Some offer exposure to more exotic or alternative investments. Others are dedicated to specific industries or economic sectors.
So, including ETFs in a well-diversified portfolio may provide access to desired investment categories without exposing you to the risk of owning a single stock. Combining equity ETFs with fixed income ETFs may help you further diversify a portfolio without having to buy a bunch of individual stocks and bonds.
Whatever you’re trying to accomplish, there’s probably an ETF out there to help you achieve it.
1 It’s important to note that just because an ETF trades on an exchange, doesn’t mean it’ll be easy to buy or sell shares. That’s determined by the liquidity – or more importantly – illiquidity of the underlying assets held by a specific fund. Investors should seek the advice of a licensed investment professional before making any investment decision.