What is an Exchange Traded Fund (ETF)?

ETFs (Exchange-Traded Funds) are investment funds that pool money from multiple investors to buy a diversified portfolio of assets, such as stocks, bonds, or commodities. Like stocks, ETFs can be bought and sold on exchanges throughout the trading day.

What are ETFs and how do they work?

Exchange-traded funds (ETFs) are investment funds that trade on stock exchanges, similar to individual equities. They provide exposure to a diversified basket of assets – such as stocks, bonds, or commodities – without requiring the purchase of each asset individually. Unlike mutual funds, ETFs can be bought and sold throughout the trading day at market prices.

ETFs work by pooling money from multiple investors into a single fund that holds a collection of assets. Investors purchase shares in the ETF, which represent partial ownership of the fund. Most ETFs are designed to track the performance of a specific index, sector, commodity or investment strategy, providing a flexible way to gain exposure to different markets.

There are many types of ETFs, including commodity ETFs, equity ETFs, bond ETFs, international ETFs and sector ETFs.

The role of exchange-traded funds in institutional investment

ETFs play a crucial role in institutional investment by providing access to diverse markets, enhancing liquidity management, and enabling swift responses to market changes.

Transition management

Institutional investors may use ETFs as transitional tools during shifts between investment strategies or fund managers, helping maintain market exposure and reducing cash drag. The creation/redemption mechanism of ETFs facilitates the conversion of traditional portfolios into ETFs and vice versa, which can potentially lower execution costs compared to fully liquidating and reinvesting capital.

Market access

ETFs offer institutional investors exposure to a broad range of market segments, including major indices like the S&P 500 and niche assets such as convertible bonds, gold, or bank loans. This approach allows institutions to align their investments with specific objectives and access targeted markets.

Liquidity & cash management

ETFs are generally highly liquid and tradable throughout the day, making them suitable for managing cash reserves. Institutions can use ETFs to maintain market exposure while keeping liquid assets readily available for unexpected needs or regulatory requirements, potentially reducing the need to liquidate long-term holdings at unfavorable prices.

Tactical asset allocation

ETFs allow institutions to adjust portfolios in response to market changes. Institutions can make short-term adjustments with relative ease, often at lower transaction costs compared to individual securities. This flexibility can support risk management and help institutions to potentially capitalize on emerging opportunities.

Cost efficiency

ETFs generally have lower expense ratios compared to other investment vehicles, providing institutions with a cost-efficient way to access various asset classes. This can be valuable for building diversified portfolios or implementing multi-asset strategies while minimizing fees that could erode long-term returns.

How do exchange traded funds (ETFs) differ from mutual funds?

ETFs and mutual funds share many similarities but also have key differences that distinguish them as investment vehicles. Below, we look at ETFs vs mutual funds.

Similarities between ETFs and mutual funds

ETFs and mutual funds share key similarities: both are professionally managed, offer diversification benefits, and provide access to a wide range of asset classes.

Diversification

ETFs provide the same diversification benefits as mutual funds, with a single fund holding hundreds – or even thousands – of securities. This broad exposure helps mitigate the risk of significant losses from any single underperforming investment.

Variety of investment options

Both ETFs and mutual funds provide access to a broad range of asset classes, including U.S. and international equities, bonds, and other securities. Investors can choose funds that match their financial goals and risk tolerance.

Professional management

Both ETFs and mutual funds are managed by professional portfolio managers. While many ETFs and mutual funds are index funds designed to track a specific index, portfolio managers ensure funds stay aligned with their target strategies.

Differences between ETFs and mutual funds

Differences between ETFs and mutual funds include their trading and pricing mechanisms, minimum investment amounts, costs involved, and management styles.

Trading and pricing

ETFs trade on exchanges, like stocks, with prices fluctuating throughout the trading day. This means the price at which you can buy or sell an ETF can vary depending on market conditions at the time of purchase.

Mutual funds trade only once per day after the markets close, with all investors receiving the same end-of-day net asset value (NAV) price.

Minimum investment amounts

ETFs typically have no minimum investment requirement beyond the cost of a single share, known as the ETF’s ‘market price’.

Mutual funds often require a set minimum investment, which can vary depending on the fund. They also allow investors to purchase fractional shares or fixed dollar amounts, while ETFs must be bought as whole shares.

Costs involved

ETFs have both explicit (visible) and implicit (hidden) costs:

• Explicit costs include trading commissions (if applicable) and operating expense ratios. These are disclosed by brokers and ETF providers.
• Implicit costs include the bid/ask spread and premium/discount to net asset value (NAV), which depend on market conditions when the ETF is traded.

Mutual funds can be purchased without trading commissions, but they may include additional fees such as sales charges (loads), early redemption fees, or management expenses.

Management styles

Both mutual funds and ETFs can be actively or passively managed, however it’s more common for ETFs to be passively managed to track the performance of a specific index.

Mutual funds, on the other hand, are often more actively managed with the goal of outperforming a benchmark index.

Key advantages of exchange traded funds (ETFs) for businesses

Investing in ETFs can offer many potential benefits for businesses, including diversification, cost-effectiveness, liquidity, and access to different asset classes.

Diversification

ETFs offer businesses a way to diversify their portfolios without the need to select individual stocks or bonds. They typically track a particular market index, such as the S&P 500, and hold a wide range of underlying assets. This diversification helps reduce the risk of individual stocks and balances returns across different asset classes.

ETFs also cover most major asset classes, international markets, specific industries, and niche sectors, providing businesses with access to markets that may be challenging to trade individually.

Potential tax efficiency

ETFs are typically more tax-efficient than mutual funds. Shares are traded between investors rather than through the sale of underlying assets, which generates fewer capital gains. This can result in potentially lower tax liabilities for ETF shareholders.

Cost-effectiveness

ETFs often have lower expense ratios compared to mutual funds. Because many ETFs are passively managed to track an index, management fees tend to be reduced. Even actively-managed ETFs tend to be more cost-effective than actively-managed mutual funds. This can be a potential advantage for businesses looking to minimize investment costs.

Liquidity

ETFs can be bought and sold on stock exchanges throughout the trading day, providing businesses with more control and flexibility in managing their investments. Unlike mutual funds, which execute trades only at the end-of-day net asset value (NAV) price, ETFs enable businesses to react quickly to market fluctuations.

Transparency

ETFs disclose their holdings daily, allowing businesses to see exactly what assets are in their portfolios. This transparency can support informed decision-making, risk management, and accountability.

Access to different asset classes

ETFs provide exposure to a wide range of asset classes, including equities, bonds, commodities, and real estate. This flexibility can help businesses tailor their portfolios to align with specific goals, such as focusing on fixed income, targeting emerging markets, or diversifying across multiple asset classes.

Understanding the cost structure of exchange traded funds (ETFs)

While ETFs are often considered cost-effective, they do involve certain costs such as the operating expense ratio (OER), potential commissions, bid/ask spreads, and changes in premiums and discounts to an ETF’s net asset value (NAV). These additional fees can affect the total cost of owning an ETF.

Expense ratios

The operating expense ratio (OER) is an annual fee charged by an ETF to cover the cost of managing and operating the fund. Expressed as a percentage of the fund’s total assets, the OER is an ongoing expense that can accumulate over time. For that reason, it’s important for long-term investors to account for the cost of expense ratios.

Passively managed ETFs often have lower expense ratios compared to actively managed mutual funds, but the fees vary depending on the ETF. For example, some lower-cost ETFs have expense ratios below 0.10% while higher-cost ETFs can have expense ratios of more than 10%.

Commission costs

Since ETFs are traded on stock exchanges, buying and selling shares may involve brokerage commissions. While many brokers now offer commission-free ETFs, others may charge trading fees that can vary between $1 to $25 or even higher. These charges can impact frequent traders more than those who plan to hold long-term.

Bid/ask spreads

The bid/ask spread is the difference between the highest price buyers are willing to pay (bid) and the lowest price sellers are willing to accept (ask) for an ETF. The spread represents a subtle but important trading cost, particularly for frequent trades.

Factors that affect the bid/ask spread include an ETF’s trading volume, liquidity of its underlying asset, and market maker competition. Highly liquid ETFs often have narrower spreads while broader spreads are more common in niche or less liquid funds.

Premium and discounts to net asset value (NAV)

ETFs trade at market prices, which may deviate from their net asset value (NAV). This can result in either a premium or a discount:

• An ETF trades at a premium when its market price is higher than its NAV. This means investors pay more for an ETF than the value of the underlying holdings.
• An ETF trades at a discount when its market price is lower than the NAV. This means investors are buying the ETF for less than the value of its holdings.

While premiums and discounts are generally small and tend to correct over time, they can influence the cost of buying or selling shares of an ETF. In some cases, they can potentially increase returns.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.