What is an ETF?

In 1989, the idea for the exchange-traded fund (ETF) was born.

Initially marketed to investors as Index Participation Shares, this innovative new product was meant to be a proxy for the S&P 500 that also traded on an exchange like a stock. After being launched, this early ETF prototype was immediately targeted by lawyers of the Chicago Mercantile Exchange (CME) for illegally behaving like a futures contract. A lawsuit ensued, and a federal judge in Chicago ruled that they needed to be withdrawn.

A year later, the case can be made that Canada was the birthplace of the first successful ETF. This time the product was called Toronto 35 Index Participation Units (TIPs 35), and it tracked the TSE-35 Index at the time. TIPs were instantly lauded for providing low-cost exposure to Canadian equities – and shortly after, many more ETFs in Canada and the United States would follow suit, including the SPDR S&P 500 Trust ETF in 1993.

How do ETFs work?

Today’s infographic from StocksToTrade.com highlights the basics around ETFs, including how they work, what type of assets they can track, and the pros and cons associated with investing in them.

In the most basic sense, an ETF is a type of fund that owns assets – like stocks, commodities, or futures – but has its ownership divided into shares that trade on stock exchanges.

In other words, investors can buy and sell ETFs whenever they want during trading hours. Like a stock, each ETF has a ticker symbol and a price that changes in real-time. However, unlike a stock, the number of shares outstanding can change daily based on the share creation and redemption mechanisms.

Pros and Cons

There are many views out there on ETFs, but it is generally accepted that they provide an inexpensive, transparent, and convenient way to get access to many different asset classes. This makes it easy to diversify a portfolio, and it also makes ETFs simple to buy and sell.

For these reasons, the passive management investment industry has taken off, and the ETF industry now has over $4 trillion of assets under management (AUM) globally. By the year 2021, ETFs are expected to surpass the $7 trillion mark for AUM.

Despite this growth and a wide range of benefits, ETFs do have some detractors.

Critics would be quick to point out that some ETFs are very thinly traded, providing wide bid/ask spreads and lower liquidity. Furthermore, there can also be instances where technical issues can cause a performance gap between the ETF and the index it tracks, known as tracking error.

As a final point, it’s worth mentioning that there is some counterparty risk with ETFs – for example, even if you “own” physically-backed gold through the SPDR Gold Trust (GLD), there is a chance that in extreme situations that you may not actually get to see the benefit of that gold. The counterparty risk stems from the possibility of a party failing to deliver on their promises, and is actually quite common to see with other types of assets, as well.