An ETF, or exchange-traded fund, is a marketable security that tracks various underlying assets, such as an index, a commodity or bonds. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares.
Because an ETF trades like a stock, its price is dependent on market forces (supply and demand). An exchange-traded fund's market price is the price at which shares in the ETF can be bought or sold on the exchanges during trading hours, while the net asset value (NAV) represents the value of each share’s portion of the fund’s underlying assets and cash at the end of the trading day.
ETFs calculate the NAV at 4 p.m. EST, after the market close. The NAV is determined by adding up the value of all assets in the fund, including assets and cash, subtracting any liabilities, and then dividing that value by the number of outstanding shares in the ETF. ETFs are structured so that the market price can be very close to the net asset value, but it could deviate a little bit over short periods of time given certain supply and demand characteristics.
Shareholders do not directly own or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets.
ETFs may provide shareholders the benefit of gains in the underlying stocks, as well as any dividends those stocks pay out. Ownership of the fund can be bought, sold and transferred just like shares of stock, since ETFs are traded on public exchanges.
ETFs – Potential Investor Benefits
Lower Fees: Many ETFs have lower fees because the operation costs are streamlined compared to mutual funds. (For instance, client service related expenses including statements are passed on to broker dealers and there are no redemption fees.)
Trading Flexibility: ETFs are traded intraday on stock exchanges like stocks.
Price Transparency: Generally, the price of an ETF traded on a stock exchange approximates the market value of the underlying securities held in the portfolio.
Access to Specific Markets or Asset Classes: ETFs can provide investors convenient access to invest in international markets and sometimes restricted markets. ETFs cover various asset classes, industries, sectors or investment styles.
ETFs – Points to Consider
Market Risk: The price of an ETF fluctuates according to market forces, such as supply and demand, as well as the changing values of the underlying assets.
Select or Asset Class Risk: ETFs may be subject to the same risks as the stocks, bonds and basket of equities that the ETF seeks to track.
Liquidity: The more often an ETF trades on a daily basis, the more likely it is to be priced fairly. The net assets an ETF holds may also be an indicator of how regularly it will trade. As a general rule of thumb, the larger an ETF the better liquidity it has, although investors should review this aspect in parallel with other key investment considerations.
Expenses: Generally speaking, the lower the net expense ratio of an ETF, the better. For example, an ETF with an expense ratio of approximately 0.40% per annum would cost $4.00 in annual fees for every $1,000 invested. An ETF with a higher net expense ratio of 0.60% would cost $6.00 in annual fees for every $1,000 invested.
ETFs – Fees and Expenses
Commissions: Investors purchasing or selling shares in an ETF typically pay a brokerage commission on each transaction. The brokerage commission is not included in the ETF fund expense ratio.
Fund operating expenses: They are reflected in the net asset value (NAV) and/or expense ratio of the fund.
Investment Advisory Fee or Management Fees (for actively managed ETFs): These are fees that are paid out of fund assets to the fund’s investment adviser (or its affiliates) for managing the fund’s investment portfolio, and administrative fees payable to the investment adviser.
Administrative Cost: They represent the costs of record– keeping, prospectus mailings, and maintaining a customer service line and website. These also include the accounting and other costs of an ETF.