What Is An ETF? And How Do They Work?

ETFs have taken over the world of investing. Everyone is getting behind ETF investing, from DIY investors to Warren Buffet, from robo-advisors to huge institutional investors. But what is an ETF? What does ETF stand for? And how do they work?

ETF stands for Exchange Traded Fund… what that means is that it’s a collection of investments, stocks, bonds etc, and those investments are grouped together into one fund that you can purchase and sell on the stock exchange.

This is slightly different than mutual funds. Mutual funds also hold a collection of investments but you purchase them through the fund provider and at a set price at the end of the day based on how much the fund is worth.

The difference is subtle but it matters, and I’ll explain why.

ETFs have grown in popularity over the last 10-years. One of those reasons has to do with low-cost index investing. Index investing is when a fund (could be an exchange traded fund, or it could be a mutual fund) tries to replicate the returns of a particular index. And an index could be anything.

For example there is an S&P 500 ETF that aims to replicate the returns of the S&P 500, a collection of the 500 largest companies in the US. An index could also be a bond index, in this case a bond ETF aims to replicate the return of a certain type of bond, maybe corporate bonds, maybe government bonds, maybe high-risk/junk bonds etc.

The amazing thing about ETFs, especially index ETFs is how little they cost, how highly diversified they are, and how simple they makes investing for the average person.

But how do ETFs work?

It’s a great question.

It’s always important to understand what you’re investing in. In this post we’ll summarize the basics of ETFs, but it’s important to understand there are many different types of ETFs.

To understand the exact ETF you’re considering investing in you should read the fund material. This material is publically available and updated regularly.

Disclaimer: This post is for educational purposes only. This does not represent investment advice. If you’re considering investing in ETFs and feel unsure, please speak with an unbiased advice-only financial planner. If necessary they can connect you with a low-cost portfolio manager.

How do ETFs work?

There are different kinds of ETFs but in this post we’re going to cover physical index ETFs. These are a very common type of ETF for DIY investors and robo-advisors.

There are other types of ETFs as well… there are synthetic ETFs, leveraged ETFs, actively managed ETFs, inverse ETFs etc. etc.

Physical ETFs are fairly easy to understand. Physical ETFs hold the actual investments that make up a particular index. For example, if an ETF wanted to replicate the S&P 500, they would purchase every single one of the 500+ stocks in the index. After that they don’t have to do anything. The ETF is exactly like the index, but on a smaller scale. If the index has 100,000 shares of Apple, the ETF would hold 100 shares. If the index has 30,000 shares of Google, the ETF would hold 30 shares. Everything is in proportion.

You can think of an index like a recipe, it’s made up of certain ingredients in certain proportions. You can double a recipe or cut a recipe in half. The result is the same, just a smaller scale. A physical ETF is like cutting the recipe by 1/100th (or more). The ingredients are the same as the index, just on a smaller scale.

As the price of each stock changes in the index, so does the value of the ETF. If Apple were to decrease in price, so would the ETF. If Google were to increase in price, so would the ETF. With physical ETFs there is very little asset turnover. There is very little need to buy/sell investments inside the fund. The only exception is when a company is added or removed from the index itself. In that case, the ETF would also need to buy/sell that stock.

Physical ETFs are simple, they hold the physical assets within the index.

Not All ETFs Are Created Equal

Not all ETFs are created equal, there are many different types of ETFs. Physical ETFs are easier to understand and are the most common type of ETF, but there are all sorts of weird and strange ETFs, many which are not great for the average investor. It’s important to understand the type of ETF you’re investing in. Some ETFs will have additional risks because of the way they’re created.

One example is a synthetic ETF. Synthetic ETFs aim to replicate a particular index or group of investments but they don’t hold the actual investment themselves. To replicate the index they use derivatives or swaps. These are complicated transactions and opens the ETF up to additional risks, one example is counter party risk. There can also be advantages to synthetic ETFs but it’s important to weigh the pro’s and con’s before investing in a synthetic ETF.

This is just one example. Other types of ETFs carry similar risks and benefits. When investing it’s important to understand those risks and benefits before purchasing a particular ETF.

How Do You Buy An ETF?

ETFs are called exchange traded funds because they are traded on the stock exchange during open hours (some can be traded after-hours as well).

This makes investing in ETFs slightly more challenging because you have to be able to make trades during the day.

This also makes it more challenging because you have to be comfortable making purchases and sales on the stock exchange using something like a discount broker.

Another small disadvantage with ETFs is that it’s hard to automate. Robo-advisors have helped to solve this problem, but at a price. A few ETFs allow automated purchases each month, quarter, year etc, but it takes some effort to set up.

Who Sets The Price Of An ETF?

The price of an ETF isn’t set by anyone, its set by the market. Usually the price is based on the underlying value of the investments inside of the ETF. For physical ETFs this isn’t too hard to calculate. You know with a high degree of certainty what an ETF holds and because these shares are actively traded on the stock market you can calculate what the ETF should be worth down to a few pennies or even fractions of a penny.

Often there are “market makers” that trade ETFs. These are high-frequency traders and/or huge institutional investors. They look for slight discrepancies in the price of an ETF vs their underlying assets. This helps keep the price of an ETF very close to what it’s actually worth.

For example, if an ETF was worth $24.65 based on its underlying assets, but only traded at $24.62 then a “market maker” would see that as an opportunity to make $0.03. They would buy millions of ETF shares until the price was up to $24.65. They make $0.03 per share but because they’re trading millions of shares this makes them a small profit.

As every day investors, we benefit because these “market makers” ensure there is a lot of liquidity (another way of saying there are a lot of people buying/selling a share). This liquidity keeps the price of an ETF very close to its actual value…. but not always…and I’ll show you an example next.

Best Practices For Trading ETFs

When it comes to ETFs there are a few best practices when it comes to buying/selling/trading. Because ETFs are actively traded on the stock exchange there is no real guarantee that the price of the ETF is the right price. This can cause some risk for the average investor. To avoid this risk there are a few best practices for trading ETFs.

1. Avoid trading ETFs around the open and close of the stock market. Often liquidity and price vary during the opening and closing of the stock market, so try to avoid these times.

2. Watch out for low trading volume. Smaller ETFs may have lower trading volume, this may mean that the price is out of sync with the underlying value of the assets within the ETF.

3. Use limit orders. A limit order lets you set a price you want to pay for an ETF. The alternative is a market order which is processed at whatever the price is a the time the order gets processed. The risk with a market order is you have no idea what the price will be, and when an ETF has low trading volume or low liquidity this can often be mean the price fluctuates more and you may not end up paying the price you assumed.

4. Avoid trading ETFs when the underlying markets are closed. For example, a Canadian should avoid purchasing a US focused ETF traded on the Canadian stock exchange when the US market is closed. The price of the ETF can sometimes get disconnected from the value of the underlying assets.

Here is a great example of why you shouldn’t trade an ETF when the underlying markets are closed. On Jan 15, 2018 XAW.TO (which holds US and international equities but is traded on the Canadian stock exchange) went up over 4% in one day and then dropped again the next.

What happened on Jan 15th, 2018? It was Martin Luther King Jr. Day in the US, a Federal holiday, and the US stock market was closed.