What Are ETFs and Why Invest in Them?

Every good portfolio depends on diversification.

A properly diversified investment strategy doesn't just spread across multiple industries. It also incorporates a variety of asset types. It has elements that move counter-cyclically against each other, so that when one segment declines another profits.

For retail investors looking to diversify their portfolio's asset types, ETFs are a good next step. Here's what you need to know about this investment class.

What Is an ETF?

An ETF, or "Exchange Traded Fund," is a fund that owns a collection of third party assets, such as stocks or bonds.

This asset trades on a stock market. As an investor you purchase it just like any ordinary share of stock.

However, unlike a stock, an ETF does not represent a single business. Instead, it owns a bundle of assets typically grouped by category. A single ETF may own (for example) a group of stocks, government bonds, commodity futures, currencies, etc. The performance of the fund is based on the net performance of its assets.

In this way an ETF is similar to a mutual fund. It profits off of collective rather than individual performance. Further, investors in an ETF don't actually own the underlying assets. They buy a share of the fund's performance, which is in turn driven by the underlying assets.

Your profits from an ETF will be based on two main factors. First, you are entitled to any dividends or other payouts made by the ETF's collection of assets. Second, you can trade your ETF shares like common stock and can profit off the capital gains of doing so.

Example of an ETF

Fund Corp. launches a new ETF focused on technology stocks. The fund purchases shares in a series of technology companies, which it holds and trades based on its own analyses. It releases 50,000 shares of stock in the fund and trades on the NASDAQ.

Growth Corp. also launches a new ETF, one focused on precious metals. The fund is built mostly of options and futures contracts, but it also buys some gold and silver outright. It too releases 50,000 shares of stock in the fund. It trades on the New York Stock Exchanges.

In both cases, an investor can buy or sell shares of the fund as a normal stock transaction. The investor would not own any of Fund Corp.'s stocks or Growth Co.'s metals. Rather they would own a share of the profits from these assets, and will collect any direct returns those assets throw off (such as dividend payments).

What Is Creation and Redemption?

This is the process by which a firm introduces shares of a new fund and revokes the shares of an existing one.

In creation investors known as "Authorized Participants" approach an ETF firm to create and release the shares of a new fund. An Authorized Participant, or "AP," is an investor with significant capital and market influence and, because of the scale of these requirements, is usually an institution.

To create shares, the Authorized Participant will acquire all of the assets the new ETF will hold. It will approach the ETF firm with this basket of assets. This firm will create a new fund and will give the AP a block of shares in this fund in increments of 50,000. These shares are priced such that the Authorized Participant receives the exact same value of shares as value of assets that it turned over.

This process can also be used with an existing fund. If an Authorized Participant introduces a basket of assets to an existing fund, that ETF can create new shares and exchange them for the assets on a dollar-for-dollar basis. (That is to say, again, the total value of shares that the AP receives will exactly match the total value of assets that it introduced into the fund.)

With an existing ETF, creation allows firms to correct overvalued shares. If the shares of a fund are worth more than its underlying assets, an Authorized Participant can purchase those assets and turn them into more valuable shares. This introduces new shares into the market, driving prices down.

In redemption, an Authorized Participant purchases ETF shares in blocks of 50,000. (This is known as a "creation unit," since ETF shares are released in blocks of 50,000.) The Authorized Participant turns this creation unit over to the ETF firm. In exchange the ETF firm hands over an equal value of the fund's assets.

Redemption is a way of managing the price of the ETF on an open market. If trading pushes fund shares below the value of its underlying assets, the Authorized Participant can begin buying shares to redeem for those assets. This scarcity will push ETF share prices back up and net the Authorized Participant arbitrage profit.

Creation and Redemption Example 

For sake of example, let's imagine a fictional university that we'll call Yarvard University. Yarvard University has an endowment worth the combined wealth of several small nations, making it an Authorized Participant due to a combination of capital and management expertise.

It wants to create a new ETF based on foreign currencies. So it puts together a basket of currencies worth $1 million. It then turns that basket over to Fund Corp. to create the ETF.

In exchange for the basket of assets, Fund Corp. creates an ETF called the New Currencies Fund. It turns over 100,000 shares, two creation units, of the New Currencies Fund to Yarvard University. These shares are worth $10 each, making them worth the same amount of money as the currencies that Yarvard turned over to Fund Corp. This creates a net neutral situation for Yarvard, which has transformed assets into shares.

It is now free to sell these shares on the open market, and places half of them on the New York Stock Exchange.

Now the ETF is trading freely to anyone, from institutional to retail investors. At first it does exceptionally well. Purchases push individual share prices high enough that the collective share prices are worth more than the underlying assets. To take advantage of this, Yarvard puts another $500,000 worth of currencies into the New Currencies Fund. It receives 50,000 shares priced at $14 per share. It sells those shares on the market, making considerably more than the half million dollars that the university spent while pushing down the fund's share price through expanded supply.

The university, however, has released too many shares. The price of the ETF drops to $8 per share, making its 150,000 outstanding shares worth less than that $1.5 million in assets the fund controls. Now Yarvard can purchase 50,000 shares of the New Currencies fund back from the marketplace. It spends $400,000 to do this and redeems that collection of shares for $500,000 in New Currencies Fund assets.

In doing so it takes shares out of the marketplace and pushes the price back up through scarcity.

Why Invest in an ETF?

There are a couple of reasons to buy an exchange traded fund.

The first is stability. Like a mutual fund or a REIT, the price of an ETF is based on a collection of underlying assets. The price of a single asset can't drag down the entire fund, nor can it lead to extraordinary profits.

An ETF's value is based on collective asset value. If one investment does poorly others can even the fund's performance out. This leads to a far more stable long-term investment that will, ideally, outperform the market without significant risk.

The second is liquidity. Unlike a mutual fund, an ETF can usually be bought or sold with low or no minimum purchase requirement. Another way ETFs are different from mutual funds is they trade like common stock on an exchange during business hours, with real-time prices. As long as someone is buying, you can sell your shares. (Some ETFs have transaction rules, but they are atypical.) Mutual fund prices are set once a day, at the close of trading. For a much more thorough discussion of ETF liquidity, see this paper by Vanguard.

Finally there is asset diversity. A firm can build exchange traded funds out of virtually any tradeable asset or commodity. This allows traders to search through a wide array of industries and underlyings in order to find the investment with which they are most comfortable. Remember, this is your money, after all.

You should feel good about where it goes.

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