How Do ETFs Work? An In-Depth Look at Exchange Traded Funds

2017-11-30 | Simpler Trading Team

2017 was a banner year for Exchange Traded Funds (ETFs).

According to data from Charles Schwab, Bloomberg, and Investment Company Institute, ETFs saw a record inflow of more than $800 billion in 2017. That inflow came at the expense of mutual funds, who saw an outflow of about $200 billion.

(Image Courtesy of Business Insider)

What’s even more impressive about ETFs earning a record $800+ billion inflow in 2017 is that the record before this was in 2016 …. At $286.5 billion.

“The passive investing “trend” is more than just a trend as investors turned their back on managed funds… as ETFs zig and funds zag…the loser here is clear. Trying to beat the benchmark of the S&P with mutual funds is out. Lower cost, tax friendly ETFs are in. Just buy the S&P or the Nasdaq ETF, not a mutual fund that cannot outperform it. The proof is in the data…”

-Raghee Horner, Simpler Trading

With such a massive increase, ETFs are clearly on the rise and can’t be ignored as a trading opportunity. However, before someone can jump in and trade exchange traded funds, you have to answer the question: What is an ETF?

If you’re wondering how ETFs work, this article breaks down the ins and outs of exchange traded funds.

ETF Definition

ETF stands for exchange traded fund.

An ETF is a collection of assets that trades like a single stock. ETFs can be an index, commodity, basket of bonds, or collection of stocks. In this way, ETFs function like mutual funds. Unlike mutual funds, however, exchange traded funds trade like common stock on the stock exchange, and experience price changes throughout the day as ETFs are bought and sold.

ETFs are quite literally funds traded on an exchange.

How are ETFs and mutual funds different?

ETFs and mutual funds are more similar than different. They both hold portfolios of stocks and bonds and are both subject to the same regulations regarding what they can own, portfolio concentration, and margins.

That being said, the biggest difference is how you buy and sell the funds. While ETFs offer traders intraday liquidity through the ability to control when and at what price point to get in and out, mutual funds trade just once a day at the close of the markets.

And while there are many other differences, the biggest notable difference between the two besides how they’re traded is the “passive” element of ETFs. Mutual funds are considered active because they’re supposed to beat the indexes they track. If a mutual fund fails to do so, or there’s a significant outflow, fund managers have to put in extra money to push the markets. This can mean selling off other assets to support the mutual funds.

With ETFs, the ETF providers want the price of the fund to be as close to the index or sector the ETF is tracking. This means buyers and sellers are working directly with each other, leaving the fund managers out for the most part. As a result, ETF providers can control the supply and demand of ETFs to keep the ETF mirroring its index. If the price gets too high, the ETF providers just create more shares.

What are the Benefits of ETFs?

ETFs are seeing such massive growth specifically because of the benefits they offer. Aside from their “passive” aspect and how much simpler ETFs are to trade over mutual funds, there are financial benefits. Mutual funds generally have penalties involved.

When you invest in a mutual fund, you’re investing through the company that manages the fund. If you sell your mutual fund before a specified length of time (usually 90 days) there is often an extra cost involved, generally 1% of the shares’ value. ETFs, on the other hand, have no minimum holding period. You can buy and sell ETFs as quickly as you like without penalty since they’re traded like a stock.

There are also tax advantages to trading ETFs over mutual funds. ETFs and mutual funds are both taxed each year based on the gains and losses within your portfolio. But ETFs have less internal trading, which creates fewer taxable events. If your portfolio is only filled with ETFs, there is only tax on your sells.

Due to low costs, ease of trading, and the ability to provide exposure to various sectors and market segments with limited risk, ETFs offer traders strong profit potential.

If you’d like to learn more about how to take advantage of ETFs in 2018, click here to check out John Carter’s free ETF options training.