ETF Series, Part 1: What Are ETFs?

Understand the major differences between stocks, mutual funds and ETFs in part one of Schwab's series on ETFs.

Some people tend to think of ETFs like single stocks, while others believe they are more akin to mutual funds. There’s no question that ETFs share characteristics with both, but understanding the differences is especially important for active traders.

When you invest in an ETF, you are buying into a pooled investment vehicle (similar to a mutual fund), but unlike mutual funds (which allow investors to buy or sell one time each day), ETFs are traded throughout the day on organized stock exchanges (just like common stocks). Most ETFs are passive, which means that they use a published index to determine which securities to hold and how to weight those securities in their portfolios. However, some ETFs are actively managed, and their investment decisions are made by a portfolio manager. Almost every investment niche – from small-cap stocks to emerging market or oil – can be filled by an ETF.

Different sources of liquidity

ETFs, mutual funds and single stocks have different sources of liquidity. When investors purchase or sell shares of mutual funds, they do so directly from fund sponsors at a price calculated at the end of each trading day. This price is called the net asset value or “NAV”, and the process of transacting directly with a fund sponsor is known as “primary market liquidity”.

ETFs also offer primary market liquidity, but only for very large transactions conducted by authorized participants (or APs). Other investors purchase and sell shares between each other and large ETF dealers (or “market makers”) on national stock exchanges (or the “secondary market”). This means that like stocks, ETFs can be bought or sold with standard, equity order types (e.g. market and limit orders), and investors can specify how long an order should be in-force (e.g. day-only, good-until-canceled, fill-or-kill, etc.). ETFs may also be purchased on margin or sold-short, and options (e.g. puts and calls) are also available on many ETFs. 

Different transaction and holding costs

Both mutual funds and ETFs earn money for their sponsors via operating expense ratios (or OERs – there is no OER on individual stocks). The OER is an annual rate that the fund charges on the total assets it holds. This fee covers portfolio management, administration and other costs. Selecting ETFs with low OERs is especially important for long-term, buy-and-hold investors since the expense ratio is an ongoing fee. Short-term traders may be more interested in the other costs associated with ETFs – commissions, bid/ask spreads and premiums/discounts to NAV.

On Schwab.com, you can look up any ETF using the Quote Detail page. Scrolling down on the page, you will see the Gross Expense and Net Expense ratios. The Net Expense Ratio is the most useful figure for understanding the current expenses that fund investors are paying. (You should also consider the impact that the gross expense ratio may have on future performance if certain arrangements limiting fees expire or are no longer available.) The figure below shows the exact location of this information.

etf series part 1 image

FOR ILLUSTRATIVE PURPOSES ONLY 

Bid/ask spreads are another important cost consideration for active traders (and represent another way in which ETFs are similar to individual stocks). The "ask" (or "offer") is the market price at which an ETF can be bought, and the "bid" is the market price at which the same ETF can be sold. The difference between these two prices is commonly known as the bid/ask spread. You can think of it as a transaction cost similar to commissions except that the spread is built into the market price and is paid on each roundtrip purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this cost becomes.

Finally, active traders should pay attention to premiums and discounts to NAV. An ETF is said to be trading at a premium when its market price is higher than its NAV. And an ETF is said to be trading at a discount when its market price is lower than its NAV. In general, most ETFs exhibit small discounts and premiums, and when material differences do arise, APs usually help the market self-correct by attempting to profit from arbitrage trades (possibly via accessing the primary market) to bring an ETF's market price and NAV back into better alignment.

We’ll discuss discounts and premiums some more in the next section ETFs Part 2: The Evolution of ETFs.

ETFs Part 4: What’s inside an ETF?
Using Trading Volume to Help Determine Entry and Exit Points