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Duration: 5:06

Instructor:

Contributor: WisdomTree

Level: Intermediate

The Main Goals: Understand what an Exchange-Traded Fund is; Comprehend how they are different from Mutual Fund; Find out about trading cost transparency, tax efficiency, and expense ratios; and learn what an index is.

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Study Notes:

This first lesson covers:

  • Characteristics of an Exchange-Traded Fund (ETF)
  • How ETFs differ from mutual funds
  • Types of ETFs
  • Defining an index

What is an Exchange Traded Fund (ETF)?

An ETF is a 1940 Act exchange-traded investment wrapper that tracks a basket of securities very similar to a mutual fund, but it is traded on an exchange. While most ETFs are designed to replicate and track an index, some are not tracking an index and are actively managed. ETF investors do not interact directly with the ETF exchange company. They trade ETF shares on an exchange.

How does an ETF differ from a mutual fund?

Buying and selling ETFs
  • ETFs are traded on an exchange intraday
  • Mutual funds are traded through the mutual fund company
  • Mutual funds are traded once a day at Net Asset Value (NAV)
Transparency
  • ETF holdings are published on a daily basis, and they are transparent at all times
  • Mutual fund holdings are published on a quarterly basis, generally on a 30-day lag
Minimum investments
  • The minimum investment for an ETF is one share
  • The price of the ETF = the minimum investment
  • Mutual funds tend to have higher minimums depending on the share class
Transparency of trading costs
  • ETF trading costs are borne by each individual investor
  • The cost is transparent through the bid-ask spread that you see on exchange
  • Costs of trading for a mutual fund are borne by all investors as the trading costs are wrapped into the NAV each day
Tax efficiency
  • ETFs are more tax efficient because of the technology of the creation redemption mechanism
  • Mutual funds are less tax efficient because trading is done inside the fund by a portfolio manager
Expense ratios
  • ETFs generally tend to be less expensive vehicles
  • Mutual funds typically have higher expense ratios and vary depending on share class liquidity
  • ETFs have daily liquidity and they have intraday liquidity
  • As long as the exchange is open, you can trade in and out of the fund
  • With mutual funds you can get in and out one time a day at NAV

What is an index?

An index is a hypothetical portfolio of investment holdings representing a segment of the financial markets. They are typically a benchmark index such as the:

S&P 500

ACSI

MSCI World

DAX

Russell 2000 Small-Cap

You cannot invest directly into an index. You must use some other sort of vehicle that tracks that index, and that is initially how ETFs were designed. Today, most ETFs still track an index.

The difference between the ETF and the index in a perfect world is called “tracking error,” and the tracking error difference between the return of the index and the ETF will be that fund’s expense ratio.

Disclosure: Wisdom Tree

WisdomTree is not affiliated with Interactive Brokers LLC

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Academy that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Academy are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Wisdom Tree and is being posted with permission from Wisdom Tree. The views expressed in this material are solely those of the author and/or Wisdom Tree and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

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