Exchange-traded funds 101 for economists

Question 1

What distinguishes ETFs from mutual funds in terms of share transactions?

Answer 1

Mutual funds conduct all transactions at the end of the day directly with investors, while ETFs emit shares to Authorized Participants (APs) for baskets of securities, who then trade these shares on exchanges with investors.

Question 2

How do ETFs and mutual funds differ in terms of share pricing?

Answer 2

ETFs trade on exchanges where investors set the price, reflecting market conditions throughout the day. ETF shares are created/redeemed between APs and the fund, ensuring prices align with Net Asset Value (NAV) at the end of the day. Mutual funds, on the other hand, price shares at NAV based on the closing price of underlying assets.

Question 3

What are the implications of transaction costs for ETFs and mutual funds?

Answer 3

Mutual funds can impose transaction costs on all investors due to the redemption/creation of shares, potentially lowering NAV. ETFs, however, directly connect buyers and sellers on exchanges, avoiding dilution of stocks and reducing the impact on other investors.

Question 4

How do ETFs offer greater transparency compared to mutual funds?

Answer 4

ETFs base their holdings on specific strategies, such as market cap, sector, or factors, leading to higher transparency. Additionally, ETFs allow for short selling, margin trading, and lending, offering more flexibility than mutual funds.

Question 5

What concerns are associated with ETFs?

Answer 5

Concerns include liquidity mismatches in the primary market for APs, particularly for small ETFs with few APs, and the risk of short selling at high volume, potentially causing ETFs with excessive long positions to go bankrupt.

Question 6

What are the benefits of ETFs compared to mutual funds?

Answer 6

ETFs offer lower fees, greater transparency, and enhanced liquidity, making them an attractive investment option.