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An Investor's Guide To Buying Exchange Traded Funds.

Article By : Patrick Mansfield | U.S. Consumer Finance
Guide To Buying Exchange Traded Funds
Exchange-Traded Funds (ETFs) have become popular over the past twenty years, leading to massive capital inflows for various ETF management companies, like Vanguard Funds and BlackRock Funds. In this article, we want to look at how an ETF works, rules for how ETFs function, and how ETFs are quite different from mutual funds.

What is an ETF?

An ETF is an investment that allows a purchaser to gain access to a wide variety of underlying assets by purchasing a single fund. While it may seem fairly similar to a traditional mutual fund at first glance, there are a couple of characteristics that make ETFs their entirely own animal. 

ETFs trade like a stock on a national stock exchange (think--NASDAQ or NYSE). They have a ticker symbol and an investor can buy and sell ETFs at any point during the market period of 9:30 AM and 4 PM, as well as during pre-and post-market hours.

There are two types of ETFs: Index ETFs and Actively Managed ETFs. Index ETFs aim to track and reflect the performance of an underlying index like the S&P 500 or the Financials Select Sector Index which tracks banks, insurance companies, and the like. An Actively Managed ETF, on the other hand, issues a prospectus that details what types of investments it is trying to make and what kinds of returns it hopes to achieve.

How is ETFs Priced?

When an ETF is originally issued, a set number of shares are issued as a part of the initial offering. Meanwhile, the ETF administrator purchases the assets that compose the ETF. 

After that, the value of the underlying assets is calculated each day at market close. This value is divided by the total number of shares outstanding to create something called the Net Asset Value (NAV).

Essentially, the NAV is what the per-share price of the ETF should be based on the current value of the underlying assets. However, since ETFs are traded daily in the primary market and NAV is only updated once a day, it is rather frequent for the ETF's shares to trade at a discount or premium to NAV.

In some instances, the fund administrator may attempt to sell or redeem shares with institutions after the market's close in order to bring the fund's price closer to its true value of NAV, but this is a very infrequent practice, especially when compared to the trading volume that takes place on a daily basis on the secondary market.

Key Differences Between ETFs and Mutual Funds. Here are just a few of the ways that ETFs are very different from mutual funds:
  • ETFs experience changes in value throughout the day while mutual funds only have one change in price per day at the market close when NAV is calculated for the fund.
  • Unlike mutual funds, ETFs do not have required capital distributions meaning that ETFs can often be a more tax-effective investment than mutual funds which are required to pay out capital gains at least once a year.
  • ETFs typically have far less fund turnover than mutual funds for a variety of reasons. Since higher turnover results in high trading costs, many ETFs have far cheaper expense ratios than their mutual fund counterparts.

Taking these three points into account, it makes fairly good sense for why mutual funds have been experiencing high capital outflows over the past ten years while ETFs have experienced a massive surge in capital inflows. They are better for expenses, taxes, liquidity, and overall transparency, which means that every serious investor should consider ETFs as a part of their portfolio objectives.
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