Investing Classroom: Exchange-traded funds

They're part fund. They're part stock. And their numbers seem to keep growing and growing.

"They" are exchange-traded funds (ETFs). They've been around for years, but as giant asset managers, such as BlackRock's Barclays Global Investors (iShares) and Vanguard, roll out scores of new offerings, ETFs have become a viable option for today's investor.

In this course, we'll discuss how ETFs differ from regular funds, what their advantages and disadvantages are, and how to determine whether they might be appropriate for you. For additional information, check out our ETF page.

What are exchange-traded funds?

Like funds, ETFs are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike regular funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. Anything you might do with a stock, you can do with an ETF.

There are a number of different equity ETFs on the market and they have also branched out into the bond arena. ETFs also come in more-exotic flavours. While conventional funds still vastly outnumber ETFs, funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a greater percentage of the ETF universe, offering relatively inexpensive access to investments, such as currencies, precious metals, or emergent industries, that heretofore have been the sole province of larger institutional and wealthy investors.

ETFs are passively managed, which means that each tracks a sector-specific, country-specific, broad-market, or other index. A manager isn't actively choosing which stocks to buy and sell.

Why has indexing been the strategy of choice for ETFs? ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. So, many ETFs have chosen the indexed route because active managers rarely disclose their portfolio holdings more frequently than regulators require.

Although ETFs are largely index-based, more actively managed or enhanced-index ETFs are not unheard of. In addition, applications have been filed to launch actively managed ETFs, but they still have much to prove to regulators, money managers, and investors about their portfolio transparency, fee structures, and real-world operations before they’d become widely available.

How do ETFs work?

Most ETFs cannot be bought from or sold back to the fund company like regular funds. Investors can only buy or redeem shares directly from the sponsoring fund company in blocks (typically 50,000 shares), and even then, the funds require in-kind transactions. With an in-kind transaction, you don't get cash when you redeem your shares; you get the underlying stocks. In practice, this means that only institutions and the very wealthy can afford to deal directly with the fund companies. The rest of us have to go through a broker to buy and sell shares.

Unlike regular funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares. To a large extent, the supply and demand for ETF shares are driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios.

However, by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs have created a mechanism that should, in theory, help prevent sustained price-to-NAV discrepancies from opening up.

If an ETF traded at a discount to its net asset value, institutional investors could assemble 50,000-share blocks in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. The actual transaction isn't quite that simple, but the idea is the same: The arbitrage opportunity would generate sufficient demand for the discounted ETF shares to close the gap between their market price and the net asset value of the underlying portfolio.

The pros of ETFs

ETFs have several clear advantages over traditional funds.

ETFs offer more flexibility: ETFs trade throughout the day, so you can buy and sell them when you want. When you buy a fund, in contrast, you're buying at the end-of-day NAV, no matter what time of day you place your order.

The annual expenses of ETFs are considerably lower than most funds': If you are considering an index fund, it's worth investigating to see if an ETF follows the same index. The ETF's expense ratio could be cheaper.

Because of their structure, ETFs should be more tax-friendly than funds: With a regular fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. All of this should make ETFs more tax-efficient than most funds, and they may therefore hold a special attraction for investors in taxable accounts. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying indices.

The cons of ETFs

Of course, these new investment options have their limitations, too.

The arbitrage mechanism keeping prices in line with NAVs isn't fail-safe: Heavily traded issues which track indices should trade right around the value of their underlying securities. But there can be a difference between an ETF's price and the NAV of its portfolio, especially for those ETFs that aren't traded frequently.

Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It's conceivable that investors wishing to sell ETFs in the midst of such an event would have to sell their shares at prices below that of the ETF's NAV.

You generally have to pay a commission to buy an ETF: The expense advantage of ETFs may also prove to be more mirage than fact for most investors. That's because you must pay commissions to buy and sell ETFs but this is changing--see our recent article for more on how investors stand to benefit from commission cuts.

ETFs' low expenses are touted as one of their key benefits, but the fact remains that if, like most of us, you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many funds. Also, for the same reason, investors who wish to trade frequently would be much better off from a cost perspective with a regular fund than with an ETF.

Do ETFs perform better?

This is the ultimate question, isn't it?

Theoretically, ETFs should perform better than similar funds. Because investors do not buy or sell shares directly from the ETF, ETFs shouldn't suffer from having to keep cash on hand to meet redemptions, or from being forced to sell stocks into a declining market for the same purpose.

But not all index funds and ETFs are created equal and a regular fund that uses futures to boost its returns could outperform an ETF that tries to exactly replicate the same index, even if the latter has a lower expense ratio.

ETFs have a lot to offer

ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, which should make them more tax-efficient than many funds.

Nevertheless, look carefully before you leap. ETFs' cost advantages aren't always as large as they might seem, and trading costs can quickly add up. Particularly if you're in the market for a fund that tracks a broad index such as the FTSE all-share, or if you wish to invest regular sums of money, the case for choosing an ETF over one of the existing low-cost fund options isn't clear-cut.

For more investing classroom lessons on equities, bonds, funds and portfolio management, check out our Learning Centre.