Questrade - Empowering you to take control of your financial future. Join the journey!

---

How do ETFs work? ​

---

Exchange-Traded Funds (ETFs) are investment funds that pool money from multiple investors to buy a diversified portfolio of assets such as Stocks, Bonds, Commodities, or other securities. ETFs are traded on stock exchanges, just like individual stocks. Here's a breakdown of how ETFs work:

1. Structure of an ETF

An ETF consists of a basket of securities designed to track the performance of an underlying asset or index. The fund’s holdings are usually transparent and disclosed daily. Investors own shares of the ETF, giving them exposure to the performance of the entire portfolio.

2. Creation and Redemption Process

ETFs operate with a unique creation and redemption mechanism, which ensures liquidity and helps keep the ETF's price aligned with the underlying assets.

• Creation: Large financial institutions called authorized participants (APs) play a key role. When demand for an ETF rises, APs buy the underlying assets in the market (e.g., stocks or bonds) and bundle them together to form ETF shares. These ETF shares are then delivered to the market, allowing investors to buy them on an exchange.
• Redemption: Conversely, if there is excess supply or a need to reduce ETF shares in circulation, APs can redeem ETF shares for the underlying assets. This process helps maintain the ETF's liquidity and ensures that its market price remains close to the value of its assets, called Net Asset Value (NAV).

3. How ETFs Trade

ETFs are traded on stock exchanges, which means:

• Real-Time Pricing: ETFs can be bought and sold throughout the trading day, unlike mutual funds, which are only traded once per day at their closing price (NAV).
• Market Orders and Limit Orders: Investors can place various types of orders, such as market orders (buying at the current price) or limit orders (buying only if the ETF hits a specific price).
• Liquidity: ETFs are generally highly liquid due to the creation and redemption mechanism, which ensures that the supply of ETF shares can adjust to meet demand.

4. Underlying Assets and NAV

The value of an ETF is tied to its underlying assets. For example, if an ETF tracks the S&P 500, the value of the ETF will rise or fall based on the performance of the 500 companies in the index. The Net Asset Value (NAV) is calculated daily, representing the total value of the assets held by the ETF divided by the number of outstanding shares.
The ETF’s market price can deviate slightly from the NAV during the trading day due to supply and demand forces, but the creation/redemption process helps keep this difference minimal.

5. Types of ETFs and Objectives

ETFs can be designed to track a wide range of assets or investment strategies:

• Index ETFs: Track a specific index (e.g., S&P 500, NASDAQ).
• Sector ETFs: Focus on a specific sector (e.g., technology, healthcare).
• Bond ETFs: Invest in fixed income securities like government or corporate bonds.
• Commodity ETFs: Provide exposure to physical commodities like gold, oil, or agricultural products.
• Thematic ETFs: Target specific investment themes like clean energy or artificial intelligence.

6. ETF Costs

​ETFs generally have lower costs than mutual funds, particularly actively managed ones, because:

• Lower Expense Ratios: Since most ETFs are passively managed (track an index), management fees are lower. Expense ratios typically range from 0.03% to 1%, depending on the ETF.
• No Load Fees: ETFs usually don’t have sales charges (loads), although brokerage commissions may apply when buying or selling ETF shares.

Many brokers now offer commission-free trading, reducing the cost of buying and selling ETFs.

7. Tax Efficiency

​ETFs are typically more tax-efficient than mutual funds due to the in-kind creation and redemption process. Since shares are exchanged for assets rather than sold for cash, ETFs don’t trigger capital gains as often. This means investors generally owe fewer taxes, particularly on capital gains distributions.

8. Dividends and Interest Payments

​ETFs can distribute income to investors in the form of:

• Dividends: If the ETF holds stocks that pay dividends, the ETF will collect those dividends and either distribute them to shareholders or reinvest them in the ETF.
• Interest Payments: Bond ETFs pay out interest collected from the bonds they hold, providing a source of regular income.

Some ETFs offer dividend reinvestment plans (DRIPs), where dividends are automatically used to purchase more shares of the ETF, compounding your investment.

9. Risks Involved in ETFs

Although ETFs are widely considered a low-cost and diversified investment vehicle, they do carry risks, including:

• Market Risk: The value of an ETF can fluctuate with the underlying assets. If the market declines, so will the value of the ETF.
• Liquidity Risk: Some niche or less popular ETFs may have lower liquidity, making it harder to buy or sell shares at the desired price.
• Tracking Error: ETFs may not perfectly track the index or asset they aim to replicate due to fees, trading costs, or other factors.
• Leveraged and Inverse ETFs: These ETFs are designed for short-term trading and are risky due to their complex structures. They amplify market returns or offer inverse exposure but can lead to substantial losses if not used properly.

Example of How an ETF Works in Practice

Let’s say you want to invest in the S&P 500 index, which represents 500 of the largest publicly traded companies in the U.S. Instead of buying shares in each of these 500 companies individually, you can buy shares in an S&P 500 ETF like the SPDR S&P 500 ETF (SPY).

• Buying SPY shares: You place an order with your broker, just like buying shares of a company. When you buy shares of SPY, you gain exposure to all 500 companies in the index.
• Performance: If the S&P 500 index rises in value, the value of your SPY shares will rise as well. If the index falls, your ETF shares will also decrease in value.
• Dividends: If some of the companies in the S&P 500 pay dividends, SPY will collect those dividends and distribute them to you as an investor.
• Liquidity: Since SPY is traded on the stock exchange, you can sell your shares during trading hours whenever you want.

Advantages of ETFs

• Diversification: ETFs offer exposure to a broad range of assets, reducing the risk tied to any single stock or bond.
• Low Cost: They generally have lower expense ratios than actively managed mutual funds.
• Liquidity: ETFs can be bought and sold at any time during the trading day, offering flexibility to investors.
• Transparency: Most ETFs disclose their holdings daily, allowing investors to know exactly what they are investing in.
• Tax Efficiency: The in-kind creation and redemption process minimizes taxable events, making ETFs more tax-efficient than mutual funds.

Disadvantages of ETFs

• Trading Costs: While many brokers now offer commission-free ETF trading, investors could still face trading fees if their broker doesn’t offer such services.
• Tracking Errors: Some ETFs may not exactly replicate the performance of the index they aim to track.
• Overtrading: Because ETFs trade like stocks, investors might be tempted to trade too frequently, incurring costs and potentially diminishing long-term returns.

Conclusion

ETFs are a flexible, low-cost, and tax-efficient way to invest in a wide range of asset classes and strategies. Whether you’re a long-term investor looking for diversified exposure or a short-term trader seeking specific market opportunities, ETFs offer a variety of options to suit different goals. However, it’s important to consider the risks, costs, and your own investment objectives before investing in ETFs.

---