What is an exchange-traded fund (ETF)?
by Jim Steel, CFA, CFP
Similar to a mutual fund, an ETF is a vehicle used to pool money from many individual investors into one big pot to invest in securities like stocks, bonds or other assets. When you buy or invest in an ETF, you receive units of that ETF, which represent your share or ownership and entitle you to all returns (positive or negative) generated by that portfolio, including interest and dividends, on a proportional basis.
The main difference between a mutual fund and an ETF is that an ETF trades on a stock exchange and can be bought and sold at any time during normal trading hours. In contrast, mutual funds do not trade on an exchange and can only be bought and sold once per day, after markets close, at the end of the day’s price.
Consider this example:
Ten thousand investors each have $10,000 to invest and they decide to pool their money to create a larger, more diversified portfolio in which they will all share in the gains or losses of the ETF. The ETF would begin as a $100 million portfolio with 10,000 unitholders. Each unit holder would own 1,000 units at $10 per unit representing their initial $10,000 investment.
The ETF would be run by a professional money manager, who charges a fee to buy and sell securities for the ETF, with a goal to make money for the investors. The $100 million would be invested in individual securities ranging from a few dozen to several thousand.
Some of the individual securities in the ETF will increase in value while others will decline. If more securities increase in value, then the ETF will generate a positive return. Conversely, if more securities decline in value, then the ETF will generate a loss.
Determining the value of a unit:
The individual securities within an ETF trade continuously on markets, and the ETF’s value is the total value of all the securities within that ETF. Throughout the day, the ETF totals the value of all securities it owns and divides by the number of units outstanding to determine the unit price. In the example above, if the value of all securities increases by 20% from $100 million to $120 million, then the value and cost of each unit increases from $10 to $12. Your initial 1,000 units bought at $10 each are now worth $12 each. Since you own 1,000 units, your initial investment is now worth $12,000. Conversely, if the value of all securities in the ETF fall, then the value of your initial investment will fall.
Investors, even those not part of the original ETF, can invest in the ETF by buying units at the current market price on a stock exchange during trading hours. These units are either issued by the ETF (i.e. there would now be more than 10,000 units outstanding) or purchased from existing unit holders, or a bit of both. The money paid by the new unit holder is used by the ETF manager who invests that cash in additional securities for the ETF.
Types of ETFs
ETFs can invest in virtually any type of security. Common mutual ETF types are:
- Equity ETFs:
- they hold only stocks
- there are many “flavours” of equity ETFs: small company ETFs, value ETFs, growth ETFs, large company ETFs, etc.
- Fixed income ETFs:
- they invest only in bonds and other fixed income investments
- Real estate ETFs:
- they invest only in real estate companies
- Balanced ETFs:
- they invest in a combination of assets such as those mentioned above
- Index ETFs
- they invest in the same securities as an underlying index (stock, bond, real estate, etc.) and provide returns almost identical to that index
- these types of ETFs are usually the least expensive as they do not require an active ETF manager and do not have high trading costs
ETFs are a way for individual investors to access diversified, professionally managed portfolios.