What is an ETF? Part 3 of 3 (video)

– Posted in: Exchange Traded Funds (ETFs)

Summary of video: What is an ETF Mutual Fund?


Key points about an ETF from this video:

  • Has slightly less overhead than an open-ended mutual fund
  • Can dynamically grow and shrink
  • Can have very low annual expenses (expense ratio)
  • Most ETFs are not actively managed

Link to first video: What is an ETF? Part 1: Open Ended Mutual Funds
Link to last video: What is an ETF? Part 2: Closed Ended Mutual Funds

Transcript of What is an ETF? Part 3: Exchange Traded Funds


So far we looked at open-end mutual funds that can grow and shrink depending on how many investors want to invest in that fund. They can grow by creating new shares and selling those shares to the general public, and they can shrink because someone who wants their money back goes to the fund and says, “You have to by this back from me at the NAV, at the net asset value per share.”

The problem with it, actually there’s a couple of problems, is that the manager here has to always keep a little cash set aside in case some of the investors come to him and say, “Hey, I want you to buy my share back. I want liquidity.” The other thing that they have to worry about, or at least from the investor’s point of view, is they can only buy or sell at the end of the day, and that will only happen at the net asset value per share. On top of that, the fund manager or whoever’s running the fund has to worry about actually transacting between all of these different investors.

Now on the other side of things we looked at the closed-end fund. The closed-end fund couldn’t dynamically grow and shrink by creating new shares or by buying them back, but what was good about them is, is that they were freely trading on exchanges, maybe on the NASDAQ or the New York Stock Exchange. Because there was none of this back and forth between the fund managers or whoever was doing the operations of the fund and the investors, they didn’t have to put cash aside and they didn’t have to have all of this overhead in dealing with the investors.

Now you’re probably saying, “Isn’t there a way or maybe there’s a way to get the best of both worlds, a fund that could grow dynamically, that could create new shares when there was demand from investors, but at the same time those new shares could be traded on an open market?” That combination, or you can view it as a combination of the two, actually exists, and they’re called exchange-traded funds, exchange-traded funds, or ETFs for short. You might say “Hey wait, isn’t a closed-end fund exchange-traded?” It is. These actually do trade hands on the stock exchanges, but these aren’t officially ETFs.

When someone tells you an ETF the way to think about it is a combination of both. What it does is it limits the interaction. When you have just a regular open-end mutual fund any individual investor can come to the fund and say, “Here is my share. Buy it back from me. Eliminate that share.” That creates a lot of overhead here. On an exchange-traded fund, only approved people, these are usually large institutions, can go to the fund and say, “I want to buy or redeem a big block of shares. In an exchange-traded fund, instead of creating one share at a time, it might create 5,000 or 10,000 or 100,000 shares at a time.

On the other side of things, if someone wanted to redeem their shares they would redeem 5,000, 10,000, or 100,000 shares at the same time. What is good there from the fund’s point of view is that they don’t have to deal with all of these small transactions. They can do big transactions with big entities. That saves them costs on overhead. Since these big people go and buy these big blocks of shares, they can then go and sell them in the open market or they could trade them in the open market. If you want to buy into an ETF, instead of buying it directly from the ETF, you would buy it from one of these big institutions that buy big blocks of shares. They’re now buying a big block of maybe this is 10,000 shares right over here, and then they will trade in the open market. You get the best of both worlds.

In general, ETFs also have lower fees. They have lower fees, one, because they don’t have to do all of this back and forth between each individual investor, and most ETFs are not actively managed. When I say actively managed I’m talking about the situation where you had Pete, and Pete says that he’s just an awesome stock picker. He can beat the market. He really researches companies and he thinks that there’s some value that he creates by doing that. When something is not actively managed, and exchange-traded funds tend to not be, they’re saying, “Look, we’re just going to buy the market,” or “We’re just going to buy some commodities.” When you go into an exchange-traded fund you’re really just trying to buy some asset class. Maybe it’s the S&P 500. Maybe it’s some type of exchange-traded funds that buys gold as assets or maybe it’s buying some other type of commodity.

Because it’s not actively managed, the argument would be that they don’t need as much in management fees, so they will have lower fees. They will have lower fees. It’s a combination. They can grow arbitrarily large. Some of the largest exchange-traded funds are super huge. They have much lower fees and they have this tradeability. You can trade them at any [time] on the markets. You don’t have to wait until the end of the day like an open-end fund.

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