What is an ETF? Part 1 of 3 (video)

– Posted in: Exchange Traded Funds (ETFs)

This is first of a 3-part series by Salman Khan to explain: what is an ETF. In short, an ETF is another simple way to own a broad portfolio of stocks, bonds, or other securities. Part 1 starts by looking at the most common type of mutual fund, the open-ended mutual funds. Part 2 introduces the concept of a closed-ended mutual fund, and part 3 compares these with the very popular Exchange Traded Fund, or ETF.

This video is produced by the Khan Academy and was uploaded to their YouTube channel in 2013. I have created a summary and transcript of each to help you find the spots that interest you and make the best use of your time.

Summary of video: What is an ETF? Part 1: Open Ended Mutual Funds

Key points from this video:

You don’t need to learn about closed end funds, but his discussion might help you understand what it means that most mutual funds are open-ended. Closed-end funds are also similar to ETFs, so this may help you understand that. Don’t concern yourself with closed-end funds too much because there is no circumstance where this would be a better idea than low-cost index funds that are open-ended.

  • Mutual funds are regulated by the Securities and Exchange Commission (SEC) in the U.S.
  • Fund managers earn a percentage of the assets under management.
  • An open-ended fund can dynamically grow or shrink.
  • The net asset value (NAV) is the total value of the assets in the fund divided by the number of shares.
  • An open-ended fund doesn’t invest 100% of investors’ money. It keeps some in cash to handle those who wish to sell sharess

Link to next video: What is an ETF? Part 2: Closed Ended Mutual Funds
Link to last video: What is an ETF? Part 3: Exchange Traded Funds


Transcript of video: What is an ETF? Part 1: Open Ended Mutual Funds

Let’s say Pete over here thinks that he’s a pretty good investor, so what he does, or he has an idea that says look I’m going to create a corporation. I’m going to get a bunch of people to contribute money to that corporation. Then I’ll manage that money, and maybe I’ll take a little fee for myself, so that I can maybe hire some analysts or get some computers, or get some office space.

What he does is he sets up a corporation. Let’s say he sets up a corporation right over here. Let’s say the way he first sets up the corporation, let’s say he just has four shares. I’m making the number really small, just to make the drawing and math easy; this wouldn’t be realistic. Normally it would be something in the hundreds or thousands of shares, or maybe even more than that. Let’s say it has four shares, and let’s say all of the four shares are owned by Pete initially, just to simply the explanation.

He puts in $400, $400 into this corporation. Another way to think about, in exchange for him putting $400 into this corporation he gets four shares, or each share is worth $100, each of these shares right over here. What he does is he registers this corporation, and I’m talking about a U.S. specific case, but there’s similar types of organizations in other countries. He registers this organization right over here with the U.S. S.E.C., Securities and Exchange Commission. He also registers himself with the S.E.C., or even better, he registers a management company that he runs with the S.E.C. Let’s call it Pete, Inc., is a corporation he starts off that he also registers with the S.E.C.

When he registers with the S.E.C. he tells them that look this company right over here we’re going to issue more shares for more people to contribute money. I’m going to manage this money right over here, and I’m going to take a percentage of the total assets under management. Sometimes you’ll see AUM—that means Assets Under Management, that will go to Pete, Inc., every year for figuring out the best place to invest this money. It’s usually on the order of about 1%, sometimes a little bit less, sometimes a little bit more, so 1% per year. Right now with only $400 assets, $400 under management it would only be about $4 per year.

Since he registered with the S.E.C. he can call himself a mutual fund, and he can solicit funds from the public, so it is a mutual fund. He has met; he has jumped through all of the hoops that the S.E.C sets up for him, so he can market, he can market himself as some type of great fund manager; we don’t know if that’s true or not. He can also solicit funds from the public; from the public. We’re going to see in future videos there are other funds, especially hedge funds that one they can’t market, and they can’t take funds from the public. Those can only take funds from certain types of sophisticated investors.

What happens in Pete’s fund, and this is going to be an open-ended mutual fund that we’re showing here, and most mutual funds are like that. Let’s say that Sal comes along, he likes Pete’s marketing materials, and he says hey, I want Pete to manage my money too. Sal goes and he gives $100 and says Pete give me a share. Pete creates another share right over here; he creates another share. He gives it to Sal, so he gets one share, that’s me, I get one share, and in exchange I gave $100 to the fund. Now the fund has; the fund has $500. This is another $100 right over here, and now Pete’s annual fee is going to be 1% of this whole thing, or $5 a year.

If this whole thing grows; let’s say this whole thing doubles to from $500, let’s say it doubles to $1,000, then that $1,000 is essentially split amongst these 5 shares now. All of the people will essentially have their money doubled, minus whatever Pete’s expenses are. Let’s say that a year goes by, and then even after paying Pete the 1%, so it had $500 of assets under management, this whole assets under management a year later goes to; let’s say it goes to $1,000. Pete either is really good, or really lucky, or a little bit of both. It goes to $1,000; so let me draw it like this. Now it is at $1,000, and it still has the same five investors here, and I’m lucky enough to be one of them.

Here are the five investors. Let me draw the shares, so there’s one, two, there, four, five shares. Now each of these shares, the $1,000 is called the N.A.V., or the Net Asset Value, let me give you that piece of terminology, it means net asset value. There’s an N.A.V. per share; the N.A.V. per share right over here is $200. I took the total N.A.V., and I divided it by the shares.

What’s special about an open-ended mutual fund is that the close, or the end of every day, either new shares can be removed from the fund, or it could be created for the funds. In the first video I showed how i wanted to buy into the fund, so I bought a share. That increased the N.A.V., and it also increased the number of shares. He had to create a share for me to buy. He didn’t sell me a share that already existed.

You can imagine after this type of a performance more people would want to buy shares. Now they would have to buy in to make things fair at $200 per share, because that’s the current N.A.V. per share. Let’s say that five more people want to buy in at $200 per share. What Pete would do, or what this mutual fund, it’s not Pete really, it’s the corporation; it would create five new shares.

One, two, three, four, five, if there was only one person that day it would create one share that day. If there was ten people that day, it would create ten shares that day, and it could keep doing this. The N.A.V. of each of these are $200, so it gives these shares to each of these people, and they have to contribute $200, so essentially it puts another $1,000 into the pool that Pete can now manage. Now he’s; the total N.A.V. for the fund is $2,000 now, and Pete will get his 1% management fee off of this entire $2,000.

Let’s say that we fast forward a little bit, we fast forward a little bit to let’s say Pete starts having a not so good year. Let’s say we fast forward a year past that, and Pete has a negative 10% return. If you started at $2,000, and that’s when you include taking his management fee out, you start at $2,000, you lose 10% in one year, so it goes down to $1,800. Let me do this in a new color. Now he’s at $1,800, and it’s not completely drawn to scale, but hopefully you get the idea. Now he is at $1,800; $1,800 but you still have a total of ten shares. You still have a total of ten shares, let me do my best to draw the ten shares.

I have one, two, three, four, five, six, seven, eight, nine, ten, these should be of equal size. Now the N.A.V. per share, N.A.V. per share is going to be $1,800 divided by 10, or $180. Let’s say that I get a little bit freaked out by this recent performance, and I have some other commitments with my money. I say, Pete you need to buy a share back from me. What Pete does, is he would give me back $180, so the total N.A.V. would lose $180, so it would go down $180, so we would take this out of it. $1,800 minus $180 is $1,620, so now it is $1,620, and they would buy back a share from you. They would cancel one of the shares, but notice the N.A.V. per share does not share. By me redeeming my share it does not change what happens to everyone else.

You have $1,620 divided by nine shares, that should still get you to be $180 per share if I did my math right. $1,800 minus $180 gets you $1620, it should still be $180 per share. This is the nature of an open-ended fund. You can keep creating shares and selling them to the public to raise more money. Or when someone wants their money back, you essentially buy the share back from them, give them their money when you buy it back, and you remove that share. An open-ended fund, really at the close of every trading day can keep growing or shrinking. It could keep adding more and more investors, or the investors can take their money back.

What’s difficult about this from the fund managers point of view is that they have to manage this. They have to manage this constant buying and selling with the public. They have to manage the paperwork, and if you think about it, they can’t have all of their money invested in relatively illiquid assets, or even in regular stocks. They have to keep some amount of their money, and it’s usually like 3 to 5%. They have to keep some of this $2,000 before he lost my money, they have to keep some of it in cash.

From an investors point of view they would say if I’m good at investing I should try to minimize the amount of cash that I have, because I’m not getting a return on cash. Because it’s open-ended, because investors might come by and say I want my money, you have to have little bit of cash as part of the asset pool in order to be able to buy people’s shares back.

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Footnotes and Credits for video: What is an ETF?

The video is a different approach to learning what an ETF is. I like it because it introduces some key vocabulary and concepts in an easy-to-understand manner. It was produced by The Khan Academy and they own the copyright. Khan Academy is a non-profit educational organization created in 2006 by educator Salman Khan to provide “a free, world-class education for anyone, anywhere”. They have given me permission to embed this via YouTube on this educational website.

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