An exchange-traded fund (ETF) is legally structured as an open-end management company, but it isn’t a mutual fund in the way you trade it. The key difference is how shares are bought and sold. ETFs trade on exchanges in the secondary market, so they’re negotiable securities.
ETFs share characteristics with both open-end and closed-end funds. They purchase and hold securities in a large portfolio on behalf of investors. ETFs calculate a daily net asset value (NAV), which reflects the current value of the fund’s assets. Because most ETFs hold many securities, buying even one share can provide instant diversification.
ETF market prices typically stay very close to NAV, even though ETF shares trade in the secondary market*. Also, ETFs can be bought on margin (using borrowed money), sold short, and transactions may involve commissions.
*ETF market prices typically match their NAVs due to a feature known as ETF arbitrage. Behind the scenes, institutional investors transact with ETF issuers to push the market price back toward NAV if it deviates. This is a fairly complex process and is unlikely to be tested in detail on the exam.
ETFs are known for tracking indexes. For example, one of the most popular ETFs is the S&P 500 “Spyder” ETF. Investors in this ETF generally profit when the S&P 500 rises and lose when it falls. This is passive management: instead of selecting a small set of securities, the fund aims to mirror a broad market segment. Since indexes represent large parts of the market, investing in a passively managed ETF is essentially a bet on the “market average.”
Research and data are often used to support this approach. For example, the Wall Street Journal ran a long-running experiment in which writers were blindfolded and had them throw darts at lists of stocks. A portfolio was built from the stocks the darts hit. 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.
Although 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 typically adds costs and fees, results like these are often cited as an argument for passive management.
*The Dow Jones Industrial Average is a well-known index tracking 30 of the largest US-based stocks.
Active management takes the opposite approach: selecting specific investments in an attempt to outperform the market (rather than “taking the average”). Active managers usually measure performance against a relevant index. For example, an active manager focused on large-cap stocks might compare results to the S&P 500. If the portfolio outperforms the S&P 500, the manager has “beaten the market.” The goal is to outperform consistently, which is difficult to do year after year. 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 management, passive investing may be appealing. ETFs offer a simple way to invest passively. 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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