What are “Exchange Traded Funds”?

Exchange Traded Funds (ETF’s) combine features of closed-ended and open-ended mutual funds i.e. they are a kind of hybrid between these two types of mutual funds. The most common types of ETFs are Equity ETFs, bond/Fixed Income ETFs, Commodity ETFs, Currency ETFs, Specialty ETFs,  Sustainable ETFs and Factor ETF’s.

ETFs trade intraday like closed-ended mutual funds, so you can trade them at any point while the market is open. Investors, just as in the case of closed-ended mutual funds, buy and sell shares of ETFs with each other and not from the ETF company or sponsor.

One of the main benefits of ETFs is that there are generally fewer taxable gain distributions, given their unique redemption process. This is because with ETF investors are generally trading with themselves, so there is no impact or sale of underlying holdings within the ETF.

Key Learning Points

  • The Net Asset Value (NAV) of an ETF is calculated as the sum of all its assets minus liabilities divided by the number of outstanding shares.
  • There are three key differences between ETFs and closed-ended mutual funds.

Exchange Traded Funds – Net Asset Value

An ETF’s Net Asset Value (NAV), is based on the most recent market closing prices of the assets in the fund and the total cash of the fund on the same day, which is the sum of all its assets minus any liabilities divided by the number of outstanding shares. The NAV is provided daily and is one of the most important data points for ETFs.

The assets represent the value of the ETF’s holdings in assets including cash, stocks, bonds, financial derivatives, and other securities.

NAV = Sum (Value of Assets – Value of Liabilities)/ No. of Shares Outstanding

The NAV of an ETF is a reference point for investors, which they can use to assess offers to purchase or sell shares of the ETF. It is also used to measure the performance of ETFs.

An ETF is said to be trading at a premium (discount), when its market price is higher (lower) than its NAV. Typically, the premium (discount) between an ETF’s NAV and its market price arises due to late market activity. However, most premium (discount) patterns for an ETF do not last long i.e. they are short-lived and will narrow on the following open.

In the case of ETFs, a fund’s NAV can be different from its market price (the market price is the price at which investors can buy or sell shares of an ETF). This is because the dynamics of supply and demand come into play in the case of ETFs, which can result in driving the market price higher or lower than an ETF’s net asset value. However, usually, the market price per share of an ETF tends to be quite close to its NAV per share.

Exchange Traded Funds and Closed-Ended Mutual Funds – Differences

Despite being able to trade shares of an ETF intraday, just like in the case of closed-ended mutual funds, ETF’s tend to track the net asset value (NAV) a lot closer than closed-ended mutual funds, due to the redemption procedure.

Next, ETF’s have typically been index funds, which has changed recently with a lot more active managers coming into the ETF fund space. However, historically, the key difference between closed-ended mutual funds and ETF’s was that closed-ended mutual funds were predominantly actively managed stock or bond funds, whereas the ETFs were typically passive index instruments.

Another key difference between the two relates to transaction costs. ETFs tend to have lower expense ratios than mutual funds but incur brokerage costs when trading in and out of ETFs. Conversely, in the case of mutual funds, one could be trading with the mutual fund company directly and in a lot of cases, there would be minimal or no trading costs.

Exchange Traded Funds, NAV – Example

Let us assume that an ETF has $12 million in securities (i.e. this is the market value of all securities), $4 million in cash, and $2 million in liabilities. Further, assume that the ETF has 2 million shares outstanding. Using the formula above, the NAV of the ETF (per share) is calculated below.