Exchange-Traded Funds
An exchange-traded fund (ETF) is an investment fund that holds a diversified portfolio of underlying assets, and can be bought and sold on stock exchanges (secondary markets), just like individual equities (stocks).
ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of stocks, which may be done either using passive or active investment strategies. Leveraged ETFs seek to deliver multiples of daily index returns by leveraging derivatives and shorting. However, leveraged ETFs typically underperform relative to objectives in the long run.
As with mutual funds, dividends, interest, and capital gains (although rare for ETFs) from the pool are distributed to ETF shareholders. However, since ETFs trade intraday, the supply of shares is regulated through a creation and redemption mechanism, which keeps market price close to the Net Asset Value (NAV) to prevent inefficiencies that create arbitrage opportunities. It involves a two-step process:
- When an ETF manager wants to issue more shares, an authorized participant (AP) buys shares of the assets associated with the ETF.
- Then, the AP sells or exchanges the assets to the ETF for new shares of the ETF at equal value.
In turn, the AP sells the ETF shares in the market for a profit if the selling price is greater than the ETF’s NAV, creating an arbitrage opportunity.
The top 3 ETFs based on Assets under Management (AUM) are the SPDR S&P 500 ETF (SPY), the iShares S&5 500 ETF (IVY), and the Vanguard S&P 500 ETF (VOO).