Understanding ETFs: Learn how they work and how investors can value ETFs

EXchange-traded funds (ETFs) have been available to investors since 1993 with the launch of the SPDR S&P 500 ETF Trust. From that first product to today, ETFs have evolved from a tool that institutional investors would use to maintain market exposure, to an indispensable tool for institutional and retail investors, not to mention active traders and equity markets. options.

Closed-end funds (CEFs) are another type of exchange-traded funds that have been available in US markets for about a century. They are popular with brokers, if only for the traditional 5% charge they charge on each fund’s initial public offering (IPO), not to mention the fact that they are well suited to complicated and illiquid strategies. . Despite this advance of nearly 100 years, the CEFs have numbered 448 with $259 billion of assets under management at the end of Q2 2022 by Institute of Investment Companies (ICI) while the only US ETF market is currently at 2,795 funds with approximately $6.3 trillion of investor assets at the end of October. Yet this pales in comparison to mutual funds, launched in 1924, with 7,411 funds and $21.2 trillion in assets (as of end of October).

Each of these types of products has its own characteristics, but their objective is the same: to provide an investment strategy to investors. For this reason, industry types call them different types of “Wrappers” because they “Wrap” around the ultimate product, the investment strategy.

Much of the initial appeal of ETFs had to do with the transparency of the funds, the relatively low fee structure, and the mechanism that facilitates the creation and redemption of new fund shares, known as the creation/creation process. redemption (a lot of time has clearly gone into crafting this name). In fact, the creation/redemption process is at the heart of not only the low fee structure of ETFs, but also its tax efficiency and the ability of market participants to ensure that the stock price of a fund better tracks the net asset value (NAV) of the underlying portfolio.

And so we are all on the same page, the Net Asset Value of an ETF represents the value of all securities (stocks, bonds) held by the ETF plus available cash minus any liabilities such as Total Expense Ratio (TER), divided by the number of shares outstanding for the ETF.

In as short a word as possible, the creation/redemption process involves the acquisition of the fund’s holdings as defined in the portfolio and their transfer to the issuer who then returns the shares of the fund. You will notice that I use the word “transfer” to describe this transaction because the process uses what is called a “transfer in kind”. This is important and this is where ETFs get their tax efficiency. ETFs benefit from a Nixon-era tax law which states that if mutual fund investors received underlying assets instead of cash when redeeming mutual fund shares, that transaction would not be considered a taxable event.

Trading ETFs – Just like a stock, right? Well, not exactly

At some point, you may have heard someone describe ETFs as products “that look like mutual funds, but trade like stocks.” What they should have said is that ETFs are like mutual funds but use the same order types as stocks. It’s a bit of a small distinction, but an important one. A common stock joke is that a company’s stock price rose because there were more buyers than sellers; but really, it’s fundamentally true. Shares are issued in fixed amounts; because of this fixed supply, fluctuations in demand determine stock prices.

ETFs, like any other open-ended investment product, have the ability to create and redeem shares as needed. For this reason, metrics such as shares outstanding and market value of the company (assets under management, or AUM for ETFs), elements that guide equity investors, are virtually meaningless when considered. is to evaluate an ETF.

This comes into play especially with newly launched ETFs. Previously, issuers relied on their fund’s Lead Market Maker (LMM) to provide around $5 million in seed capital. These days, funds are launched with as little as $500,000. While this is effective for the LMM and helps the issuer bring the product to market, it is very difficult for investors to look at a fund with less than $1 million and feel comfortable placing a transaction. The reality is that due to the creation/redemption process, the liquidity of an ETF should be judged by the liquidity of its underlying portfolio holdings and not the size of the fund itself.

Let’s say I’m starting a new fund that has $1 million in assets but holds Apple (AAPL), Microsoft (MSFT)and Amazon (AMZN). Although the fund may be small in terms of assets under management, it is actually a gateway to access nearly $5 trillion in market capitalization. Although this is an extreme example, it illustrates that fund size should not influence your decision to invest in a fund if you understand and like the strategy.

One aspect of ETF trading that mirrors stock trading is the attention traders and investors pay to the bid/ask spread. One thing I always tell investors is that the Bid/Ask spread for stocks or ETFs can be thought of as a sort of suggested price. You can sell at auction and buy on demand, but no one is forcing you to. In fact, many trading platforms strongly encourage their clients to trade using limit orders so that they can trade within the bid/ask spread. Another pro tip is to avoid trading ETFs at the open, if only because even though the ETF shares may be ready to trade, some of the holdings may not have not yet begun to trade and that you can trade shares of the fund using certain stale underlying holding prices.

Now that you have some tips on the mechanics of ETF trading, let’s take a look at how you can go about understanding an ETF’s strategy.

ETF valuation

ETFs began as a vehicle that offered broad market exposure to investors. Since then, they have expanded to include just about every asset class and increasingly complex and powerful strategies that were traditionally only available to Institutional and Ultra-High Net Worth investors. Suffice it to say that there are currently a number of asset classes and strategies available to investors. With this, how can investors understand what investment strategy a fund manager is executing?

The answer is that to the extent fund issuers prepare fact sheets and develop websites to explain their approach to investing, there are usually a number of gaps in those presentations.

Passive ETFs

For passive funds, the index methodology is your best and most direct source to truly understand not only the overall approach, but also the specifics of the stock selection process and position weighting methodology. The one glaring exception to this rule is the S&P 500 Index, with a methodology that outlines some initial qualification criteria, but then indicates on page 11 that “selection of constituents is at the discretion of the index committee…” But otherwise just about every other index provider provides real guidance on how they select individual securities for their indices, even relatively complicated Smart Beta type indices.

Actively managed ETFs

Actively managed ETFs, while benchmarked against an index, are not required to track the index, so there is no index methodology to guide you in stock selection and position weighting . That being said, the fund’s prospectus is a great place to get this information. The good news is that these descriptions are in the first few pages of the document. Another piece of good news is that ETF issuers are making the fund’s prospectus and other regulatory filings available on their websites.

Reading about an investment process can be a great way to learn, but with ETFs you learn exactly what a manager does by downloading a fund’s holdings on any given day. Some issuers may make it more difficult to find portfolio securities than others, but nonetheless, if you want to get into the details of a fund, you can.

put it all together

In this article, we’ve reviewed high-level ETF plumbing, pointers to ETF trading, and tips for understanding how ETF portfolio managers execute their strategy. When it comes to evaluating funds, performance, your risk appetite and your overall asset allocation are key factors in deciding where to invest your money. Once you’ve selected a strategy, chances are there are a number of ETFs that could fill that spot in your portfolio. One of the things I look for in my own fund selection process is how accurately the fund executes the strategy relative to what is advertised by the issuer.

The first step is to understand the strategy by reviewing the index prospectus and methodology, then I move on to analyzing the performance of the fund and finally I download the fund holdings and cross-reference them with what I have learned from the prospectus or index methodology. Once I have made my final decision and am ready to trade, I will place a reasonable limit order. Realistically, I tend to invest for the longer term rather than actively trading funds, so while I want to get closer to my ideal entry point, I’m not about to lose a position for a penny here or there.

While this is a relatively high-level overview, I hope readers can turn this knowledge into wisdom as they continue to embrace ETFs in their investment allocation decisions.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.