Exchange-Traded Funds (ETFs) have revolutionized investing, offering a cost-effective and diversified way to participate in the financial markets. But what exactly is an ETF stock, and how does it work? This guide will delve into the intricacies of ETFs, exploring their features, benefits, and how they compare to other investment vehicles.
ETFs vs. Mutual Funds vs. Stocks
To understand what an ETF stock is, it’s helpful to compare them to mutual funds and individual stocks:
| Exchange-Traded Funds (ETFs) | Mutual Funds | Stocks |
|---|---|---|
| Tracks a basket of securities or commodities. | Pooled investments into bonds, securities, and other instruments. | Shares in listed companies. |
| Prices can trade at a premium or at a loss to the net asset value (NAV) of the fund. | Prices trade at the net asset value of the overall fund. | Returns are based on their actual performance in the markets. |
| Traded during regular market hours, just like stocks. | Can be bought and sold only at the end of a trading day. | Traded during regular market hours. |
| Some can be purchased commission-free and are generally cheaper than mutual funds. | Some do not charge load fees, but most are more expensive than ETFs because they charge management fees. | Can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase. |
| Do not involve actual ownership of securities by retail investors. | Own the securities in their basket. | Involve ownership of the security. |
| Diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and instruments. | Diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Risk is concentrated in a stock’s performance. Diversity would have to be achieved by buying other stocks. |
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Alt: Table comparing key features of ETFs, mutual funds, and stocks, highlighting differences in trading, pricing, and diversification.
Dividends and Taxes
ETF investors can benefit from companies within the fund that pay dividends. Dividends are a portion of earnings allocated to investors. ETF shareholders are entitled to a share of earned interest or dividends and may get a residual value if the fund is liquidated.
ETFs are generally more tax-efficient than mutual funds. This is because most buying and selling occur through an exchange, and the ETF sponsor doesn’t need to redeem shares each time an investor wishes to sell. In contrast, with a mutual fund, each time an investor sells their shares, they sell it back to the fund, potentially incurring a tax liability for all shareholders of the fund.
Creation and Redemption
The supply of ETF shares is regulated through creation and redemption, which involves large specialized investors called authorized participants (APs). When an ETF manager wants to issue additional shares, the AP buys shares of the stocks from the index (e.g., the S&P 500) and sells or exchanges them to the ETF for new ETF shares at an equal value. The AP then sells the ETF shares in the market for a profit.
When an AP sells stocks to the ETF sponsor in return for shares in the ETF, the block of shares used in the transaction is called a creation unit. If an ETF closes with a share price of $101 and the value of the stocks that the ETF owns is only worth $100 on a per-share basis, then the fund’s price of $101 was traded at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.
Conversely, an AP can also buy shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. This process, called redemption, reduces the number of ETF shares. The amount of redemption and creation activity depends on market demand and whether the ETF is trading at a discount or premium to the value of its assets.
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Alt: Diagram illustrating the ETF creation and redemption process involving authorized participants (APs), ETF sponsors, and the open market.
ETFs in the United Kingdom
The U.K. ETF market is one of the largest and most diverse in Europe. ETFs listed on the London Stock Exchange (LSE) offer exposure to various asset classes and markets, including equities, fixed income, commodities, currencies, real estate, and alternative investments.
Buying ETFs in the U.K. allows inclusion in Individual Savings Accounts (ISAs), which are tax-efficient savings vehicles that allow people to invest up to £20,000 per year without paying any income or capital gains tax on their returns. Another benefit is that ETFs attract no stamp duty, which is a tax levied on ordinary share transactions in the U.K.
U.K. investors can buy shares in U.S.-listed companies from the U.K., but due to local and European regulations, they’re not allowed to purchase U.S.-listed ETFs in the U.K. Some U.K.-based ETFs track U.S. markets; they have ‘UCITS’ (Undertakings for the Collective Investment in Transferable Securities) in their name. This means the fund is fully regulated in the U.K. and allowed to track U.S. investments. For broad-based exposure to U.K. equities, there are several ETFs that track the FTSE 100 index, which consists of the 100 largest publicly listed companies in the country. The HSBC FTSE UCITS ETF is listed on the London Stock Exchange and trades under the ticker symbol HUKX. As of January 2024, the ETF has an ongoing charge of 0.07% and a dividend yield of 3.62%.
The First ETF
The SPDR S&P 500 ETF (SPY), launched by State Street Global Advisors on Jan. 22, 1993, is often credited as the first exchange-traded fund (ETF). However, some precursors to SPY existed, including Index Participation Units listed on the Toronto Stock Exchange (TSX) in 1990, which tracked the Toronto 35 Index.
ETFs vs. Index Funds
An index fund usually refers to a mutual fund that tracks an index. An index ETF is constructed similarly, holding the stocks of an index. However, ETFs tend to be more cost-effective and liquid than index mutual funds. Furthermore, ETFs can be bought throughout the trading day, while mutual funds trade via a broker after the close of each trading day.
Alt: Visual representation highlighting the key differences between index funds and ETFs, focusing on trading flexibility and cost-effectiveness.
Diversification with ETFs
Nearly all ETFs offer diversification relative to purchasing individual stocks. However, some ETFs are highly concentrated, either in the number of different securities they hold or in the weighting of those securities. For example, a fund may concentrate half of its assets in two or three positions, offering less diversification than other funds with broader asset distribution. Therefore, it’s crucial to review an ETF’s holdings before investing to ensure it aligns with your diversification goals.
The Bottom Line
Exchange-traded funds provide a cost-effective way to gain exposure to a broad basket of securities with a limited budget. Investors can build a portfolio that holds one or many ETFs. Instead of buying individual stocks, investors buy shares of a fund that targets a representative cross-section of the wider market. However, remember to consider all associated expenses before investing in an ETF. By understanding what an ETF stock is and how it works, investors can make informed decisions and potentially achieve their financial goals.
