Exchange-traded funds (ETFs) were developed in 1993 as a new way to invest in the securities of an index. ETF shares represent a basket of stocks or bonds. The firm sponsoring the ETF compiles a portfolio of securities and places it into a specially structured account; in exchange, it receives a block of shares (not unlike a fund’s shares) of equal value. The firm then sells those shares in the form of a single security to investors on the open market.
ETF shareholders receive a proportionate amount of any income, capital gains, or losses realized by the underlying portfolio. The share prices are linked to the value of the underlying portfolios. An ETF’s actual share price, however, is determined by market supply and demand, just like the price of an individual stock or bond.
A typical S&P 500 ETF, for example, is backed by a portfolio that invests in the stocks contained in the S&P 500 Index. However, ETFs are not limited to the U.S. blue chip stock market. Investment companies have developed ETFs that represent various bond markets, non-U.S. indexes, and market sectors. At some point, they might also represent actively managed portfolios. However, actively managed ETFs have been slow to develop. ETFs can only function properly if the contents of their underlying portfolios are continuously available to the market. Most active managers prefer not to reveal daily portfolio changes in order to avoid market front-running (a practice in which investors load up on shares of companies that large mutual funds purchase, thereby making the trades more costly for the fund firms), which can diminish potential returns for fund investors.
Today’s ETFs are similar to index funds in that they constitute a single investment providing access to a diversified index portfolio. ETFs are different in that they trade on an exchange like a stock or bond. For that reason, ETFs have a number of unique properties:
- ETFs are traded on the open market, and their prices respond quickly to market activity.
- You can place stop and limit orders on ETFs (if permitted by your broker), sell ETFs short (subject to exchange rules), or buy ETFs on margin (with borrowed money).
- Trades in ETFs incur commissions and possibly other brokerage fees.
- Generally, ETFs have low management fees.
- ETFs typically provide high tax efficiency because they have low portfolio turnover.
Their qualities make ETFs attractive to many investors, but there can be disadvantages for some investors. See “The Potential Risks and Rewards of ETFs” to learn more.
For a more detailed explanation of ETFs, see our Insights piece.
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