What are ETFs?
Exchange-Traded Funds (ETFs) provide an efficient and simple way to invest in different segments of our economy. For example, PurePlay Capital’s ETFs are designed to give investors an easy way to access innovation areas.
ETFs are listed on various exchanges like NASDAQ, NYSE, or BATS.
ETFs act similar to stocks when traded. An investor can trade an ETF during market hours like trading shares of an equity. Simply call up a broker or log onto an online brokerage and put in an order.
An ETF is a portfolio of securities, much like a mutual fund. ETFs can be based off an existing index, or a unique mixture determined by the fund manager.
ETFs possess two different types of liquidity, making them easily tradable. First, ETF shares are bought and sold like a stock on an exchange, making it easy for investors to trade the ETF. Second, ETFs possess an underlying liquidity due to their unique creation and redemption process, so low trading volume should not impact an investor’s ability to trade the ETF during market hours.
ETFs disclose their holdings daily. Passive ETF holdings should reflect the index to which they are tethered. Active ETFs are similarly transparent and required by the SEC to disclose the holdings everyday. Mutual funds are not required to disclose their holdings daily, and stocks are naturally transparent as a single security.
ETFs are packaged and sold as a unique collection of securities. Holding one ETF could offer an investor exposure to hundreds of securities, instead of just buying and selling individual stocks and bonds.
The ETF creation and redemption process, which uses in-kind transfers of securities, makes index ETFs relatively more tax efficient when compared to mutual funds and stocks. Mutual funds are taxed when a manager sells securities within the fund and a capital gain is distributed. A tax must be paid on a stock every time it is sold.
ETF expense ratios generally are lower than mutual funds. According to Morningstar Research, the average ETF expense ratio in 2014 was 0.44%, which compares to 1.25% the average mutual fund charges. Compared to buying single stocks, mutual fund and ETF investors bear their pro rata share of the fund’s brokerage cost but do not pay the full brokerage fees for several individual stocks to gain broader exposure to a segment of the market.
Active Versus Passive ETFs
Active ETF management is based on research and the portfolio manager’s discretion within the investment policies of the ETF, as with an active mutual fund. Most ETFs in the active space are based on pre-existing strategies, just in a different wrapper. Because the manager is picking stocks based on research, actively managed funds are not tethered to an index.
Index (Passive) ETFs
Index or Passive ETFs are tethered to an underlying index, like the S&P 500 or Dow Jones Industrial Average. Fund management is focused on matching the underlying index, instead of making decisions based on fundamental or quantitative research. A index ETF follows its underlying index as its benchmark.