An exchange-traded fund (ETF) is technically structured as an open-end management company, but it’s not a mutual fund. The key difference is how you trade it. ETFs are organized like open-end funds, but they don’t transact like mutual funds. As the name suggests, ETFs trade on exchanges in the secondary market and are 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. This is similar to index funds, which are mutual funds designed to track specific indexes.
ETF market prices typically follow their NAVs very closely, even though ETF shares trade in the secondary market*. Also, ETFs can be bought on margin (with borrowed money), sold short, and commissions may apply to transactions.
*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 push the market price back toward NAV if it deviates. This fairly complex process is unlikely to be encountered on the exam.
ETFs are widely 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 trying to select a small set of “best” securities, the fund aims to capture the performance of a broad market segment. Since indexes track large market segments, 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 an experiment for many years that involved blindfolding its writers and having them throw darts at lists of stocks. A portfolio was constructed from the stocks the darts landed on. 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 also involves added 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 (instead of “taking the average”) with the goal of outperforming the market. Active money managers (like the professionals in the dart-throwing article) usually measure performance against a relevant index.
For example, an investor using active management in 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.” Active strategies aim to beat their benchmark 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 throwing darts can produce results similar to spending time and money on research, passive investing may make more sense. ETFs offer a simple way to invest passively. Today, 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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