An exchange-traded fund (ETF) is legally structured as an open-end management company, but it isn’t a mutual fund in the way investors buy and sell it. The key difference is how it trades. Mutual fund shares are bought from and redeemed with the fund company, while ETFs trade on an exchange in the secondary market. That makes ETFs negotiable securities.
ETFs share features of both open-end and closed-end funds. Like other investment companies, they pool investor money to purchase and hold a diversified portfolio of securities. ETFs calculate a net asset value (NAV) each day, reflecting the current value of the fund’s underlying assets.
Because most ETFs hold many securities, buying even one share can provide instant diversification.
ETF shares trade in the secondary market, and their market prices typically stay very close to NAV.* Like stocks, ETFs can generally be bought on margin (using borrowed funds), sold short**, and trades may involve commissions.
*ETF market prices typically match their NAVs due to a feature known as ETF arbitrage. Behind the scenes, institutional investors perform transactions with ETF issuers to manipulate the market price back to NAV if it deviates. This fairly complex process is unlikely to be encountered on the exam.
**A short sale involves the sale of borrowed securities, typically as a means of betting against that security.
ETFs are best known for tracking indexes. For example, one of the most widely traded ETFs is the S&P 500 “Spyder” ETF. Investors in this ETF generally benefit when the S&P 500 rises and lose value when it falls.
This approach is called passive management. Instead of trying to select a small set of “best” securities, passive management aims to capture the performance of a broad market segment. Since indexes represent large parts of the market, buying a passively managed ETF is essentially a bet on the market’s average return.
Research and data often support this approach. For example, the Wall Street Journal ran an experiment for many years that involved blindfolding its writers and having them throw darts at lists of stocks. A portfolio was constructed with all the stocks the darts landed on. Surprisingly, some of these portfolios performed better than professionally managed funds. A quote from the linked article above:
Over 100 six-month contests, the pros have racked up an average gain of 10.9%, compared with 4.5% for the dart throwers and 6.8% for the Dow industrials. The pros have come out ahead of both the darts and the Dow industrials 44 times.
While the professionals averaged higher returns than the Dow Jones Industrial Average* and the dart throwers, they beat both only 44% of the time. Since professional (active) management also adds costs and fees, results like these are often used to argue for passive management.
*The Dow Jones Industrial Average is a well-known index tracking 30 of the largest US-based stocks.
Active management is the opposite approach. It involves selecting specific investments in an attempt to outperform the market (rather than accepting the market average). Active managers typically measure performance against a relevant index. For example, an active manager focused on large-cap stocks would likely compare results to the S&P 500. If the portfolio outperforms the S&P 500, the manager has “beaten the market.”
The challenge is consistency: outperforming a benchmark year after year is difficult. According to this CNBC article:
Just 26% of all actively managed funds beat the returns of their index-fund rivals over the decade through December 2021
If an investor believes that random selection can produce results similar to paid research and professional selection, passive investing may be a better fit. ETFs make passive investing easy because thousands of ETFs track many different indexes. These three ETFs are the most likely to be referenced on the exam:
The names of these ETFs are a word play on the indexes they follow.
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