Exchange Traded Funds: Mechanics and Applications

Exchange-traded funds (ETFs) have grown rapidly since their invention in the early 1990s, in large part because of their low associated cost, exchange access, holdings transparency, and range of asset classes available. Growth in ETFs has also been driven by the increased use of index-based investing. ETF investors need to understand how these products work and trade and how to choose from the numerous options available. Although many ETFs are organized under the same regulation as mutual fund products, there are important differences related to trading and tax efficiency. ETFs have features that can make them more tax efficient than traditional mutual funds, and not all ETFs are organized like mutual funds. ETFs can be based on derivative strategies, use leverage and shorting, and be offered in alternate structures, such as exchange-traded notes (ETNs), which have their own unique risks.

Understanding how ETF shares are created and redeemed is key to understanding how these products can add value in a portfolio. Because so many ETFs track indexes, understanding their index tracking or tracking error is also critical. Investors should also understand how to assess an ETF’s trading costs, including differences between the ETF’s market price and the fair value of its portfolio holdings.

We start with a discussion of the primary and secondary markets for ETFs, including the creation/redemption process, before moving on to important investor considerations, such as costs and risks. We then explain how ETFs are use in strategic, tactical, and portfolio efficiency applications.