As we have seen, ETFs offer a wide range of benefits to investors. They are easy-to-use, liquid investment vehicles offering a high degree of transparency, access to a broad range of markets and asset classes, and generally low fees. Since these benefits can be traced to the special way in which ETFs are structured, it can be revealing to take a quick look under the hood.
Like a mutual fund, an ETF is an investment entity that creates shares in itself and uses the funds it receives to make investments in securities markets. The price of the ETF shares is tied to the performance of these underlying securities.
ETFs do not however sell their shares directly to investors. Instead, investors buy and sell them among themselves on exchanges just as they do stocks. This intraday valuation and tradability is one of the fundamental differences between ETFs and mutual funds – and is the result of the mechanism, known as the creation/redemption process, that is used to get ETF shares on an exchange.
With a little help from their friends
The power of this mechanism is tied to the fact that ETFs rely on special third parties to buy and sell their securities – which they then can move from the primary market transaction to the secondary markets. These third parties often also act as market makers, ensuring the liquidity of ETF shares and keeping bid/ask spreads narrow.
Although not a requirement, most ETFs track an index. This can be done either by buying baskets of securities that reflect the index’s relative weightings – known as “full replication” – or by relying on a financial instrument (for example a swap contract) to replicate the performance of the index. Either way, the ETF effectively outsources its portfolio management to the index provider, benefitting from its expertise and saving costs at the same time.
Despite this reliance on third parties, the quality of the ETF provider can make a difference. Similar ETFs may have different levels of liquidity, for instance. Some providers are also able to more closely track their underlying indices than others. There can be other differences as well.
That said, thanks to their basic underlying principles, almost all ETFs offer a similar set of benefits, including flexibility, transparency, diversification and low cost. That’s a powerful mechanism.