What it means
An ETF is a pooled investment. The fund holds the underlying shares, and investors own units of the fund, so a single purchase gives exposure to dozens or even thousands of companies.
Most stock ETFs are passive, which means they aim to copy the performance of an index rather than beat it. Some are actively managed, where a manager chooses the holdings and charges a higher fee.
The ongoing charge is expressed as an expense ratio, which is the percentage of the fund taken each year to cover running costs. The key feature is that units can be traded throughout the day at a market price, unlike traditional mutual funds that are priced once a day.
Special institutions known as authorised participants create and redeem units, which keeps the market price close to the value of the underlying holdings. Small gaps can still appear, especially in thinly traded funds or when markets are stressed.
For businesses, stock ETFs are a simple way to invest surplus cash that is not needed for several years, to run a staff pension scheme or to give executives broad market exposure. They reduce the risk that comes from owning one company.
They do not remove market risk, though, because a fund holding hundreds of shares will still fall in a broad downturn. Before buying, check the index followed, the fees, the size of the fund and the average trading spread.
Also check whether the fund holds the shares directly or uses derivatives (contracts whose value comes from other assets), because that changes the risks.
In practice
Real-world examples.
Example
A family-run manufacturer has $300,000 of surplus cash it will not need for five years. The owner invests it in a broad stock ETF rather than picking individual companies. The fund spreads the money across hundreds of businesses at a low annual fee.
Example
A marketing manager joining a company pension scheme chooses between several funds. She picks a global stock ETF with an expense ratio of 0.20% a year because it is cheap and diversified. Over thirty years the fee difference between that and a 1.20% fund adds up to a large sum.
Example
A treasurer at a university endowment wants quick exposure to technology shares while a manager search is under way. Buying a sector ETF gives her the exposure in a day at a known cost. Once the manager is chosen, she sells the ETF.
Formula
Calculation
Net asset value per unit (NAV) = (total assets - total liabilities) / units outstanding
Premium or discount = (market price - NAV) / NAV
A stock ETF holds assets of $520,000,000 and has liabilities of $2,000,000, with 10,000,000 units in issue. NAV = (520,000,000 - 2,000,000) / 10,000,000 = 518,000,000 / 10,000,000 = $51.80. The units trade at $51.95, so premium = (51.95 - 51.80) / 51.80 = 0.15 / 51.80 = 0.29%. The investor pays about 0.29% more than the underlying value.Case study
Seen in the real world.
Oakridge Dental Group is an illustrative, fictional company with $1,500,000 of surplus cash and a plan to build a new clinic in about four years. The owners first considered buying shares in three companies they knew, but their adviser pointed out how much one bad result would hurt.
They split the money between a broad stock ETF and a short-term bond fund, with 60% in the ETF. The ETF cost 0.10% a year, or $900 on its $900,000 allocation, while an actively managed alternative they were quoted would have cost about $9,000 a year.
In the second year the stock market fell 15%, and the ETF portion dropped by roughly $135,000. The illustrative point is that the ETF gave cheap diversification, yet it did not shield the money from a market fall, so the owners were glad they had kept the clinic money in the bond fund.
Watch out
Common mistakes.
- Assuming an ETF is safe because it is diversified, when a broad stock ETF will still fall when the whole market falls.
- Comparing funds on past performance alone and ignoring fees, which compound against the investor every year.
- Ignoring the trading spread and the premium or discount to NAV, which can add real cost when buying thinly traded ETFs.
Questions
People also ask.
How is a stock ETF different from a mutual fund?
An ETF trades on an exchange all day at a changing price, while a traditional mutual fund is bought and sold once a day at its net asset value.
Does an ETF pay dividends?
Yes, the fund collects dividends from its holdings and either pays them to investors or reinvests them, depending on the fund type.
Can an ETF lose all its value?
A broad stock ETF is very unlikely to go to zero because it holds many companies, but a narrow, leveraged or inverse fund can lose most of its value quickly.
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