Many folks are familiar with the concept of mutual funds, in which a manager pools money from a large number of
investors and creates a portfolio of stocks, bonds, or other assets. Exchangetraded funds, while less familiar to
some, provide another way to pool money for investing. ETFs and mutual
funds share many characteristics, but ETFs have unique features that make
18them an increasingly popular alternative to mutual funds. Both types of investments can provide instant diversification, which lowers the investment’s overall risk. That’s because, in a diversified portfolio, any one asset can only do only limited damage to the portfolio’s return.
Before you get started trading ETFs, it’s important to understand how they work and how they can benefit you. With this knowledge, you can formulate an ETF trading strategy that meets your risk/reward objectives.
Anatomy of an ETF
ETFs begin life as initial public offerings of stock shares. The fund issuer
raises capital privately and uses it to purchase a portfolio of assets. At the
time of the IPO, the first set of investors buy ETF stock shares directly from the
managing fund. Each stock share represents ownership of a slice of the
investment portfolio controlled by the;fund manager. Once investors gobble up
the initial offering of shares, the stock begins to trade in the secondary market – on stock exchanges and over-the counter.
20This is a primary difference between ETFs and mutual funds.
Mutual funds issue and redeem fund shares as necessary in order to meet
the demands of investors. After the close of the normal trading day, the
fund manager issues new shares to buyers and cashes out or exchanges
existing shares from sellers. The price per share is called the share
net asset value, or NAV, which is the total net value of the portfolio
divided by the number of shares outstanding. NAV varies from day to
day based upon performance, purchases, and redemptions. The
fund company recalculates the NAV 21every trading day after the market closes.
In contrast, ETFs trade just like normal stocks on an exchange. You
open a brokerage account and purchase or sell shares by placing
orders through your account. The price per share depends on the
supply and demand for the shares at the time your trade executes. That
price might differ slightly from the portfolio’s NAV, although, as we’ll
see, ETFs have special procedures to keep share prices close to their NAVs
Trading ETF shares as stock provides investors with certain benefits when compared to mutual fund trading:
1. You can trade shares whenever the market is open. This means you can
react quickly to news, something not possible with mutual funds. You can day trade ETFs – that is, open and
close positions throughout the day –not something you can do with
2. You pay a commission for each purchase and sale. If you use a discount broker, you can usually trade several hundred shares for less than $10.
3. ETF management fees are normally lower than are those of equivalent
mutual funds, because ETF investors don’t have to pay for the share
management operations provided by mutual funds.
4. In rapidly moving markets, ETF shares might trade at a premium or
discount to NAV. This can be a positive or negative, depending on
your circumstances. For example, in a strongly uptrending market, you
might be able to sell your ETF shares for more than their NAV per share