Exchange-traded fund
An exchange-traded fund is a type of investment fund that is also an exchange-traded product; i.e., it is bought and sold on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, debts, futures contracts, and/or commodities such as gold bars. Many ETFs provide some level of diversification compared to owning an individual stock.
Details
An ETF divides ownership of itself into shares that are held by shareholders. Depending on the country, the legal structure of an ETF can be a corporation, trust, open-end management investment company, or unit investment trust. Shareholders indirectly own the assets of the fund and are entitled to a share of the profits, such as interest or dividends, and would be entitled to any residual value if the fund undergoes liquidation. They also receive annual reports. An ETF generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occur.The largest ETFs, which passively track stock market indices, have annual expense ratios as low as 0.03% of the amount invested, although specialty ETFs can have annual fees of 1% or more of the amount invested. These fees are paid to the ETF issuer out of dividends received from the underlying holdings or from the sale of assets.
In the United States, there is $5.4trillion invested in equity ETFs and $1.4trillion invested in fixed-income ETFs. In Europe, there is $1.0trillion invested in equity ETFs and $0.4trillion invested in fixed-income ETFs. In Asia, there is $0.9trillion invested in equity ETFs and $0.1trillion invested in fixed-income ETFs. In the first quarter of 2023, trading in ETFs accounted for 32% of the total dollar volume of stock market trading in the US, 11% of trading volume in Europe, and 13% of trading volume in Asia.
In the US, the largest ETF issuers are BlackRock iShares with a 34% market share, Vanguard with a 29% market share, State Street Global Advisors with a 14% market share, Invesco with a 5% market share, and Charles Schwab with a 4% market share.
ETFs are regulated by governmental bodies and are subject to securities laws.
Closed-end funds are not considered to be ETFs; even though they are funds and are traded on an exchange they do not change the number of shares they have issued, unlike an ETF. Exchange-traded notes are debt instruments that are not exchange-traded funds.
ETFs vis-à-vis mutual funds
ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the day on stock exchanges, whereas mutual funds are bought and sold from the issuer based on their price at day's end. ETFs are also more transparent since their holdings are generally published online daily and, in the United States, are more tax efficient than mutual funds. Unlike mutual funds, ETFs trade on a stock exchange, can be sold short, can be purchased using funds borrowed from a stockbroker, and can be purchased and sold using limit orders, with the buyer or seller aware of the price per share in advance.Costs and fees
Both ETFs and mutual funds charge annual expense ratios that range from 0.02% of the investment value to upwards of 1% of the investment value. Mutual funds generally have higher annual fees since they have higher marketing, distribution and accounting expenses. ETFs are also generally cheaper to operate since, unlike mutual funds, they do not have to buy and sell securities and maintain cash reserves to accommodate shareholder purchases and redemptions.Stockbrokers may charge different commissions, if any, for the purchase and sale of ETFs and mutual funds. In addition, sales of ETFs in the United States are subject to transaction fees that the national securities exchanges must pay to the SEC under section 31 of the Securities Exchange Act of 1934, which, as of February 2023, is $8 per $1 million in transaction proceeds. Many mutual funds can be bought commission-free from the issuer, although some charge front-end or back-end loads, while ETFs do not have loads at all.
Taxation
In the United States, ETFs can be more attractive tax-wise than mutual funds for transactions made in taxable accounts. However, there are no tax benefits to ETFs compared to mutual funds in the United Kingdom and Germany.In the US, whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, its shareholders who hold the fund in taxable accounts often pay capital gains taxes on their share of the gain. However, 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.
Trading
ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds, which can only be traded at the end of the trading day. Also unlike mutual funds, investors can execute the same types of trades that they can with a stock, such as limit orders, which allow investors to specify the price points at which they are willing to trade, stop-loss orders, margin buying, hedging strategies, and there is no minimum investment requirement. ETFs can be traded frequently to hedge risk or implement market timing investment strategies, whereas many mutual funds have restrictions on frequent trading.Options, including put options and call options, can be written or purchased on most ETFs – which is not possible with mutual funds, allowing investors to implement strategies such as covered calls on ETFs. There are also several ETFs that implement covered call strategies within the funds.
Many mutual funds must be held in an account at the issuing firm, while ETFs can be traded via any stockbroker. Some stockbrokers do not allow for automatic recurring investments or trading fractional shares of ETFs, while these are allowed by all mutual fund issuers.
The most popular ETFs such as those tracking the S&P 500 trade tens of millions of shares per day and have strong market liquidity, while there are many ETFs that do not trade very often, and thus might be difficult to sell compared to more liquid ETFs. The most active ETFs are very liquid, with high regular trading volume and tight bid-ask spreads, and the price thus fluctuates throughout the day. This is in contrast with mutual funds, where all purchases or sales on a given day are executed at the same price at the end of the trading day.
Transparency
Issuers are required by regulators to publish the composition of their portfolios on their websites daily, or quarterly in the case of active non-transparent ETFs.ETFs are priced continuously throughout the trading day and therefore have price transparency.