How ETFs work?
by ETFZone staff
ETFs are securities certificates that state legal right of ownership over part of a basket of individual stock
certificates. Several different kinds of financial firms are needed for ETFs to come into being, trade at prices
that closely match their underlying assets, and unwind when investors no longer want them. Laying all the
groundwork is the fund manager. This is the main backer behind any ETF, and they must submit a detailed
plan for how the ETF will operate to be given permission by the SEC to proceed.
In theory all that a fund manager needs to do is establish clear procedures and describe precisely the
composition of the ETF (which changes infrequently) to the other firms involved in ETF creation and
redemption. In practice, however, only the very biggest institutional money management firms with
experience in indexing tend to play this role, such as The Vanguard Group and Barclays Global Investors.
They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks
necessary for the creation process. They also create demand by lining up customers, either institutional or
retail, to buy a newly introduced ETF.
The creation of an ETF officially begins with an authorized participant, also referred to as a market maker or
specialist. Highly scrutinized for their integrity and operational competence, these middlemen assemble the
appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping. These
baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The
custodial bank doublechecks that the basket represents the requested ETF and forwards the ETF shares on
to the authorized participant. This is a so-called in-kind trade of essentially equivalent items that does not
trigger capital gains for investors.
The custodial bank holds the basket of stocks in the fund's account for the fund manager to monitor. There
isn't too much activity in these accounts, but some cash comes into them for dividends and there are a
variety of oversight tasks to perform. Some managers have leeway to use derivatives to track an index.
This flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the
same US government agency that records individual stock sales and keeps the official record of these
transactions. It records ETF transfer of title just like any stock. It provides an extra layer of assurance
Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open
market. From then on ETF shares are sold and resold freely among investors on the open market.
Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open market
and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks
which are then sold on the open market or typically returned to their loanees.
What motivates each player? The fund manager takes a small portion of the fund's annual assets as their
fee, clearly stated in the prospectus available to all investors. The investors who loan stocks to make up a
basket make a small interest fee for the favor. The custodial bank makes a small portion of assets likewise,
usually paid for by the fund manager out of management fees. The authorized participant is primarily driven
by profits from the difference in price between the basket of stocks and the ETF and on part of the bid-ask
spread of the ETF itself. Whenever there is an opportunity to earn a little by buying one and selling the other,
the authorized participant will jump in.
The process might seem cumbersome but it does allow for transparency and liquidity at modest cost.
Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that
they can exit at any time, and even the authorized participant's fees are guaranteed to be modest. If one
allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step
in and take profit on the difference, so their competition tends to keep ETF prices very close to it underlying
Net Asset Value (value of component stocks).
ETFs: General Questions
o What are ETFs?
o Where are ETFs traded?
o How do I buy or sell ETFs?
o What's the typical cost of an ETF?
o How liquid are ETFs?
o Do ETFs pay dividend income?
o Who buys ETFs?
o What kind of risks do ETFs carry?
o What's the difference between the market price and NAV an ETF?
o What is the ETF prospectus?
What are ETFs?
Exchange traded funds (ETFs) are low cost index funds that trade like stocks. ETFs
track a variety of stock, bond, commodity, real estate and currency indexes. Investors
can choose broadly diversified funds or narrowly focused funds. ETFs can be
leveraged with margin, hedged with options, shorted or bought and held.
Where are ETFs traded?
ETFs are listed and traded on major U.S. and foreign stock exchanges. They can be
bought or sold via a regular brokerage account. In the United States, the New York
Stock Exchange (NYSE) and the NASDAQ list most exchange-traded funds.
How do I buy or sell ETFs?
ETFs are listed and traded with ticker symbols, the same way as individual stocks.
They can be bought or sold through a full service or discount broker/dealer. A
brokerage commission to buy or sell will usually apply.
What's the typical cost of an ETF?
There are a number of factors that affect the cost of an ETF, including the expense
ratio and the brokerage commission to acquire the fund. Generally, the expense ratios
of ETFs are consistently lower versus actively managed mutual funds. Also, expense
ratios will vary among ETF companies, but this information can be obtained from the
How liquid are ETFs?
The liquidity of an ETF is mainly affected by the liquidity of the underlying stocks or
bonds in its index - not the trading volume of the fund itself. The reason is because it's
less complicated for authorized participants or market makers to assemble creation
units for liquid stocks or bonds. (Creation units are baskets of underlying stocks or
bonds within an ETF that can be exchanged for ETF shares.) It's possible for ETFs
with low trading volume to still be liquid.
Do ETFs pay dividend income?
The dividend income received from underlying stocks or bonds in an ETF's portfolio
are distributed to fund shareholders. The frequency of dividend payments can be
quarterly or monthly, depending on the fund. Many bond ETFs pay out dividends
Who buys ETFs?
ETFs have gained favor with both individual investors, financial professionals and
institutional investors because of their low expenses, tax efficiency, diversification,
transparency, trading flexibility and intraday liquidity. ETFs are a convenient way to
gain instant market exposure to global markets.
What kind of risks do ETFs carry?
Equity-based exchange traded funds have a similar risk profile to those of equity
mutual funds, while fixed income-based ETFs have a risk profile that approximates
bond mutual funds. Performance returns will fluctuate and are subject to market
conditions, the economic environment and other related factors. ETF shares may be
valued more or valued less than their original cost at the time of sale or redemption.
ETFs that invest in foreign securities have higher risk characteristics versus domestic
securities. Past performance is no guarantee of future results
What's the difference between the market price and NAV an ETF?
Net Asset Value (NAV) refers to a fund's total assets minus its liabilities, whereas
market price refers to the quoted price that an ETF is trading at on an exchange.
While large premiums/discounts are rare, at times the NAV and market price of ETFs
What is the ETF prospectus?
The ETF prospectus is a legal document that explains the fund's investment
objectives, risks, fees and other expenses. Investors should carefully consider
information contained in the prospectus, including investment objectives, risks,
charges and expenses. You should always read the prospectus carefully before
Exchange-Traded Notes (ETNs)
o What are ETNs?
o What are the risks of ETNs?
What are ETNs?
ETNs are debt instruments linked to the performance of a single commodity, currency
or index. They have a set maturity date and they do not usually pay an annual coupon
or specified dividend rate. ETNs can be traded or redeemed before the maturity date.
If the note is held to maturity, the investor is paid the return of the note's underlying
index, minus the annual expense ratio.
What are the risks of ETNs?
ETNs carry issuer risk which is tied to the credit worthiness of the financial institution
backing the note. If the issuer's financial condition deteriorates, it could negatively
impact the value of the ETN, regardless of how its underlying index performs.
ETFs vs. Mutual Funds
o Are ETFs better than mutual funds?
o Are ETFs less expensive?
Are ETFs better than mutual funds?
Each kind of investment has its strengths and weaknesses. Any fair comparison of the
two should be done in the context of not just performance, but tax efficiency,
fees/total ownership costs, risks, and if the fund objectives match your financial
objectives. Always refer to a prospectus for detailed information.
Are ETFs less expensive?
Generally speaking, in buying or selling ETFs, you will pay a trade commission to a
broker, whereas in buying or selling no-load mutual funds, you generally pay none.
However, some brokers impose a commission to buy or sell no-load mutual funds.
Other so-called "no transaction fee" mutual funds don't charge a commission, but may
carry higher expense ratios. Ultimately, any fair cost analysis between ETFs and
mutual funds should look at the total spectrum of expenses - not just the commission
to acquire the ETF or mutual fund. Specifically, investors also need to pay attention to
the ongoing expenses, such as management fees, as well as the often ignored tax
implications of owning a mutual fund versus an ETF.
ETFs vs. Stocks
o How are exchange-traded funds like stocks?
o Are individual stocks better than ETFs?
How are exchange-traded funds like stocks?
While ETFs are traded on a securities exchange, and can also be sold short like
individual stocks they are not the same. Rather, ETFs are more diversified and
composed of an underlying portfolio of securities that track an index.
Are individual stocks better than ETFs?
Not necessarily. Each kind of investment has its strengths and weaknesses. Any fair
comparison of the two, should be done in the context of not just performance, but
risks and if the investment matches the financial objective of the investor.
ETFs and Taxes
o How are ETFs taxed?
o How is dividend income from ETFs taxed?
o How are commodity ETFs taxed?
o What are the tax advantages of ETFs?
How are ETFs taxed?
ETFs are required to distribute dividends and capital gains to shareholders. This is
usually done at the end of each year and these distributions can be caused by index
rebalancing, diversification rules, or other factors. Also, anytime you sell your fund
this could generate tax consequences. Consult your tax advisor for more specific
How is dividend income from ETFs taxed?
ETFs, like mutual funds, are required to distribute dividends to shareholders.
Dividends are taxable as income to the shareholder, unless you own the ETF in a
The Tax Relief Reconciliation Act of 2003 reduced the maximum tax rate on
dividends from 35% to 15% for most investors. The rule also applies to dividend
distributions paid to ETF shareholders. The dividend income from REIT ETFs may
not be subject to the lower tax rate, although the capital-gains component of dividend
income applies under the lower tax. Consult your tax advisor for more specific
How are commodity ETFs taxed?
Many commodity ETFs uses futures contracts to obtain their commodities exposure
while others, like the SPDR Gold Shares (GLD), own the physical commodity. Under
current tax law, commodity ETFs that hold physical gold or silver are taxed at a long-
term capital gains rate of 28%. Commodity products that use futures contracts are
taxed each year even if you don't sell them. Capital gains are currently taxed at a
hybrid rate of 60% long-term and 40% short-term gains.
What are the tax advantages of ETFs?
Most ETFs are designed to track set benchmarks, which translates into fewer trades
and lower portfolio turnover. This reduces the frequency of tax gain distributions. By
comparison, actively managed portfolios generally have higher turnover, which can
translate into untimely or more frequent tax distributions.