ETFs, or exchange-traded funds, are publicly traded closed-end funds that have become extremely popular in the last ten years. Despite their prominence, the functioning of such funds is not always well-understood. Tried and true mutual funds are open-ended, meaning that when investors purchase shares, the invested money goes directly into the fund, and new shares are issued directly to those investors. When those investors want to sell their shares, they redeem them directly with the mutual fund, which then pays the investors. ETFs, on the other hand, are closed-end funds, meaning a specfic number of shares are created during the initial offering of the fund, and this number does not vary for the life of the fund. When ETF shares are bought and sold, they are traded between investors on exchanges, meaning they tend to be liquid.
Q. Of course ETFs are an enormous industry at this point, well over $1T, covering all sorts of securities. But today we’re not going to talk about all the many ETF styles and investment possibilites, we’re going to talk about how they actually work.
A. Right. Many people wonder how they really differ from mutual funds. After all, they’re both funds, right? But ETFs always seem to have lower expense ratios. Partly, that’s because most ETFs are tied to an index and don’t have to pay active managers. But an even more important reason is how they are structured compared to mutual funds.
Q. OK, so mutual funds are still far more popular than ETFs, so let’s start with the plumbing people are used to.
A. Right. When you buy or sell a mutual fund share, you interact directly with the fund, which issues a new share when new money in, or redeems old shares when an investor leaves the fund. It either buys stock with the new money, or sells stock to meet the redemption. Obviously, the mutual fund has to have significant internal infrastructure to handle all that. With ETFs, on the other hand, the trades takes place on the exchange… the fund itself is not involved, so it doesn’t have the cost of that infrastructure.
Q. So the cost to the investor is therefore different, right? With “no load” mutual fund shares, there’s no brokerage fee involved in the purchase or sale as there are with ETFs. On the other hand, mutual funds have higher operational costs to cover that infrastructure for issuing and redeeming shares, which the investors effectively pay.
A. Exactly. Now, if you think about it for a second, you’ll come to this question. Is that a free ride for the ETF? If it has a fixed set of securities inside it, and it doesn’t redeem out and issue new shares like a mutual fund, how do you keep the price of the fund from getting out of whack with the total prices of the underlying securities?
Q. I see what you mean. In traded closed end fund, for example, we know that the market price is usually different from the total prices of the securities in the fund. But that would blow the whole reason for investing in ETFs.
A. Right. So the big trick is something called an “Authorized Participant”. These are specified financial institutions outside the fund. Say that the AP sees that the price of the ETF is getting too high in relation to the stocks inside it… there’s more demand for the ETF shares than there is supply. The AP goes into the market and buys a basket of stocks that exactly replicate the holdings of the ETF. It then delivers that basket of stocks to the fund, in exchange for new ETF shares. And it then sells those shares into the market, which brings the price of the ETF back into line.
Q. And it makes a small profit on the arbitrage there, I guess.
A. Exactly. That’s why the ETF prices stay in line with their underlying investments: APs are constantly out there arbitraging away any price disparities, by either forcing the issuance or redemption of new ETF shares.
Q. So, coming back to the top, with ETFs, the APs and the market are performing that function, whereas mutual funds have to do it themselves.
A. That’s it. So all else being equal, ETFs are cheaper to operate. But, as we mentioned before, they’re usually more expensive to buy and sell.