Immediately we change to an necessary a part of the inventory market ecosystem: Change-traded funds (ETFs).
ETFs are one of the vital profitable monetary improvements of the final 30 years. Since their launch (in Canada) in 1990, ETFs have proliferated and their property have grown all over the world. In line with ETFGI, within the U.S., there at the moment are over 4,000 ETFs (proper axis, open circles) with property totaling over $10 trillion (left axis, bars).
Chart 1: ETF asset progress from 2003 to April 2025
What’s an ETF?
An ETF is each a mutual fund and a inventory!
So, whenever you see an ETF ticker, like QQQ for the Nasdaq-100 ETF, keep in mind it represents a managed portfolio of securities, in addition to a inventory you possibly can commerce your self.
Chart 2: An ETF just like the QQQ is a fund that holds the highest 100 non-financial shares on the Nasdaq trade, in the identical weights because the Nasdaq-100 Index® (asset weights as of Might 19, 2025)
Most ETFs are legally structured and managed as a mutual fund, following the foundations of the 1940 Act. Like different mutual funds, an ETF is a professionally managed portfolio that holds a diversified group of shares. Many (however not all) are additionally index funds, which implies their portfolio managers maintain virtually all shares within the index however do little or no buying and selling.
A key distinction between mutual funds and ETFs is when and the way an investor buys the fund:
- For mutual funds, buyers ship checks to the asset supervisor, that are invested by the portfolio supervisor on the finish of the day. The buyers get “items” of the fund on the end-of-day unit value, which is calculated from the “web asset worth” of the fund.
- ETFs, in the meantime, commerce all day on a inventory market, similar to a inventory. That permits buyers purchase and promote the ETF on the present market value – typically with out the underlying shares needing to be purchased or offered. That additionally means every ETF has a inventory ticker with bids, provides and trades. Importantly, on the finish of every day, arbitrageurs can do creations and redemptions of ETF shares, which is how the fund receives web investments over the day.
To ensure that ETFs to be created and redeemed every single day, the U.S. Securities and Change Fee (SEC) has particular exemptions from the buying and selling guidelines within the Change Act of 1934. Among the buying and selling guidelines had been designed to use to corporations, like guidelines round new share points and accounting information when an organization raises new money raises. Exemptions from these enable the ETF to “situation new shares” any day they want.
What’s an ETP?
A few of you could have seen in Chart 1 a small extra class referred to as “ETPs” and puzzled what that was.
- ETP stands for exchange-traded product. It’s normally used as a extra inclusive umbrella time period that features all exchange-traded securities that enable creations and redemptions, and due to this fact arbitrage. For probably the most half: ETPs = ETFs + ETNs.
- ETN stands for exchange-traded observe. ETNs are largely bank-issued notes with whole return swaps into no matter asset class is desired. This implies the financial institution is accountable for managing the underlying hedge portfolio, and a purchaser is uncovered to some credit score threat (if the financial institution defaults). Nonetheless, a swap additionally means they observe their index completely (earlier than charges).
There are different methods to construction ETPs, too. Some maintain money and futures or bodily commodities, typically to trace commodities (like: IBIT, iShares Bitcoin Belief ETF). These are typically regulated below the 1933 Securities Act, which regulates new safety issuance, however not how investments inside them are managed.
Immediately, to maintain issues easy for the remainder of this put up, we’ll use the time period ETF.
ETFs evolution: Extra selection and extra lively portfolios for buyers
Early ETFs had been solely index funds. SPY, the S&P 500 index ETF, was the primary to launch within the U.S. It was adopted by Choose Sector funds like XLE (Power) and XLK (Know-how), which additionally observe S&P indexes. Within the Nineties, there have been additionally tradable nation index funds run by banks that later grew to become a number of the earliest iShares nation funds.
Over time, the SEC closed the hole between traditional end-of-day inventory choice (lively funds) like mutual funds, closed-end funds and ETFs, permitting for extra lively inventory choice with straightforward arbitrage mechanisms. First with ETFs monitoring good beta indexes, then with clear lively ETFs.
Importantly, all of these ETFs allowed buyers (and market makers) to see the entire ETF portfolio every single day. That made arbitrage a lot simpler.
Chart 3: Evolution of various ETFs, because the SEC closed the hole between index ETFs and lively mutual funds
Today many ETFs aren’t market-cap weighted; some are actively choosing shares, and others mirror the portfolios of established lively mutual funds. ETFs allow you to purchase bonds, worldwide shares, choices and even commodity exposures – all utilizing a inventory brokerage account.
Among the latest ETFs additionally provide a portfolio of shares which can be a straightforward method to spend money on some widespread themes.
What’s web asset worth?
Web asset worth (NAV) is the worth of the ETF portfolio per ETF share.
It sounds comparatively easy to calculate – you simply add up the:
You may consider it as the worth it is best to pay for the ETF, besides that’s not at all times true!
That’s normally as a result of the shares within the portfolio aren’t buying and selling at the very same time because the ETF. In these situations, the portfolio consists of some outdated (or “stale”) costs.
In some circumstances, the time delay between markets may be massive, and intraday NAVs are only a information to the ETF’s present worth. For instance:
- Chinese language shares in an ETF listed within the U.S.: The Chinese language market is closed when the U.S. ETF ticker begins buying and selling, and the U.S. market closes earlier than all of the underlying shares open for the subsequent day. What you will note is that the U.S. ETF will “value in” new information that has occurred for the reason that Chinese language market closed.
- Bond ETFs: Bond markets publish no public quotes (or “tapes” of stay historic trades) for the underlying bond markets, and lots of bonds don’t even commerce every single day. That makes it unattainable to precisely worth the underlying bond portfolio throughout the present day.
How do ETFs observe their portfolio?
Even when these NAV timing variations are massive, it might probably assist to take a look at how the ETFs observe their underlying portfolios over longer durations.
The information largely exhibits that ETF portfolio managers are superb at replicating their goal index. For instance, after we take a look at the efficiency of the QQQ ETF versus the Nasdaq-100 Index (its benchmark), we see it fully overlaps over a interval of greater than a decade.
Chart 4: ETFs observe goal portfolios very properly
How a lot do ETFs commerce?
As a gaggle, ETFs commerce over $186 billion every single day.
That’s greater than double what the entire European inventory market trades every day. Though it’s nonetheless not as a lot as the corporate shares within the U.S. market commerce, which is nearer to $386 billion every day.
The U.S. futures markets commerce much more fairness publicity, including as much as round $670 billion every day. Nonetheless, we should always spotlight that futures buying and selling is generally targeting the only S&P 500 publicity.
Importantly, ETFs enable for a a lot larger number of hedges than futures. However in comparison with shares, in addition they provide diversification in a single commerce.
Chart 5: ETF buying and selling and creations versus inventory and futures buying and selling
Some ETFs commerce lots. Usually with out a lot impression on the underlying shares. In truth, the worth of creations and redemptions is a fraction of the worth of ETF buying and selling, which appears to verify that usually an ETF purchaser trades instantly with an ETF vendor – and inventory arbitrage is required.
Chart 6: Many ETFs commerce with spreads less expensive than the underlying portfolio
That is sensible whenever you take a look at the unfold of many ETFs – which is a fraction of the unfold on the underlying shares. That makes buying and selling ETFs typically cheaper than buying and selling the underlying basket of shares, as:
- The spreads on ETFs are sometimes smaller and cheaper to cross (Chart 6).
- The bid and provide liquidity on the ETF are normally deeper than for any single inventory (Chart 7).
Chart 7: Some ETFs are extraordinarily liquid; others are used extra selectively
Some ETFs commerce little or no (in truth, many are cropped out of the left of Chart 6). Nonetheless, in our personal research, we discovered that even these thinly traded ETFs typically have tight ETF spreads with frequent quote adjustments. That’s an indication that the market makers are competitively pricing the ETF, prepared for any commerce to happen. ETF itemizing exchanges, like Nasdaq, make investments lots in ETF liquidity packages, together with utilizing rebates and market tiers, to help market makers in quoting thinly traded merchandise tightly.
Who trades ETFs?
So, who does probably the most ETF buying and selling?
We all know from current analysis that retail buyers like shopping for ETFs, with round 81% of their web shopping for going into ETFs.
Chart 8: Retail love ETFs; information recommend their web influx has been about $341 billion since 2019
Nonetheless, the identical analysis exhibits that retail contributes to lower than 6.4% of all buying and selling every day in ETFs.
It will appear that mutual funds are not massive merchants of ETFs both, as ETFs hardly ever present up in mutual fund 13F holdings.
That almost definitely means ETFs are closely traded by hedge funds, banks and market makers. That’s a testomony to their low buying and selling prices, offering efficient hedging of extra personalized exposures than futures. It’s also supported by the truth that the 100 most liquid ETFs make up 70.5% of all ETF buying and selling, regardless of being simply 3% of all ETFs (bigger circles are excessive and proper in Chart 7).
What publicity do ETFs give?
Keep in mind, simply because ETFs are U.S.-listed shares doesn’t imply buyers are shopping for U.S. inventory exposures after they commerce all ETFs.
Knowledge from FactSet on underlying asset exposures exhibits that many ETFs haven’t any U.S. inventory publicity in any respect. For instance, the chart under exhibits ETFs present buyers with entry to bonds (orange), commodities (gold) and abroad shares (darkish inexperienced).
In truth:
- Worldwide inventory ETFs add as much as round $1.7 trillion in property.
- Bond ETFs add as much as over $1.9 trillion in property.
There are even ETFs with publicity to a variety of various kinds, sizes, sectors of shares, in addition to ETFs that embrace shares and choices.
Chart 9: ETFs give buyers publicity to quite a lot of asset lessons, areas, kinds and sectors – in a single commerce; bond ETFs and abroad shares every account for over $1.4 trillion of the property in ETFs
What retains ETFs monitoring NAV: Arbitrage
It’s necessary for buyers that the ETF value tracks its benchmark index. That’s due to three key options:
- Portfolio managers are good at monitoring the underlying index, ensuring NAV replicates the index returns.
- Arbitrageurs and market makers very effectively hold ETFs precisely priced and near a “stay market” NAV.
- Creation and redemption make arbitrage cheaper and extra environment friendly.
With futures and choices, market makers know that at expiry, their lengthy and brief positions will collapse, and income can be locked in. Nonetheless, that requires arbitrageurs to carry (generally massive) positions for weeks and even months. That provides to the financing prices and dangers whereas ready for expiry, which can be factored into futures costs. It might additionally end in persistent premiums or reductions.
In distinction, the creation and redemption mechanism enable an arbitrageur to lock in income and scale back their positions any evening they select.
How ETF arbitrage works
Be aware that each the ETF and the portfolio have final commerce costs in addition to bids and provides.
Usually, the unfold of the ETF can be tighter than the unfold of the portfolio (as proven in Chart 10). Then, the ETF is cheaper to commerce for a purchaser or a vendor of the portfolio.
Chart 10: How arbitrageurs take a look at ETF valuation
Arbitrageurs might want to cross each spreads to lock in both sides of their commerce and safe their income immediately. Meaning:
- Creation arbitrage (ETF is wealthy): When the ETF bid is increased than all of the shares’ provides — Promoting the ETF on the bid + shopping for all of the shares at their provides = income.
- Redemption arbitrage (ETF is affordable): When the ETF provide is decrease than all of the shares’ bids — Shopping for the ETF on the provides + Promoting all of the shares at their bids = income (Chart 11 under).
Doing this buying and selling stops the ETF from dislocating farther from the portfolio NAV – preserving costs of the ETF and the NAV in-line.
Chart 11: Arbitrage is triggered when each spreads may be crossed profitably
As soon as the redemption arbitrage commerce above is accomplished, the arbitrager can be lengthy on the ETF and brief the basket of shares.
The arbitrageur can have an virtually good hedge, so market actions received’t change their income. However there are different prices they could have to pay, from the price of borrowing shorted shares to the settlement charges from the entire trades.
How do creations and redemptions work?
Creations and redemptions make arbitrage even cheaper. They permit arbitrageurs to scale back their lengthy and brief positions, decreasing the financing and inventory borrowing prices we famous above.
The way it works is any Licensed Participant (somebody accepted by the ETF supervisor) can ship their ETF again to the ETF supervisor and, in return, the ETF supervisor will ship all of them the underlying shares within the basket (or vice-versa) any evening, for a small charge.
If we begin from the arbitrage commerce in Chart 11, we are able to present how this works forward of trades being settled (Chart 12):
Chart 12: ETF redemption mechanism (three steps to web out your hedged positions)
The arbitraged place includes a brief inventory and a protracted ETF place (Chart 12, Step 1). As a result of that is completely hedged, extra market actions received’t have an effect on income, so there isn’t any market threat.
In a redemption, the arbitrageur provides the lengthy ETF again to the ETF supervisor, and the ETF supervisor provides the arbitrageur the underlying shares from the portfolio in return.
The impact of that is proven within the gray field under (Chart 12, Step 2), the place successfully the ETF shares are exchanged for actual shares.
That leaves the arbitrageur with lengthy and brief inventory positions in the identical shares that web to zero, requiring no shares to be delivered on settlement (Chart 12, Step 3). This reduces the steadiness sheet prices of arbitrage to zero and eliminates the necessity to borrow inventory to carry the brief place.
Nonetheless, the arbitrageur does have some extra prices they should account for that vary from virtually nothing to hundreds of {dollars}:
- ETF managers cost (normally mounted) prices to do creation and redemption, designed to offset settlement and custody prices of the ETF portfolio.
- Arbitrageurs may also have to pay custodians to settle every line of their trades.
The ETF portfolio does no buying and selling
Redemptions do characterize web outflows from the ETF. Nonetheless, the promoting of shares happens throughout the day, by the arbitrageur, because of extra ETF promoting. Importantly, the ETF portfolio supervisor sees no money flows and does no buying and selling.
ETF creation and redemptions are simply 4% of ETF buying and selling
Creation and redemption trades are prone to occur lower than you suppose. They add as much as simply 4.2% of all ETF buying and selling, and generally market-makers will redeem SPY to create VOO if they’re doing S&P 500 arbitrage. That’s in keeping with the truth that Chart 6 exhibits that ETFs are sometimes cheaper to purchase and promote than the portfolio of shares themselves.
A lot of different research discover that lower than 10% of ETF buying and selling probably flows by to underlying firm shares.
Briefly, it’s unlikely that ETF buying and selling (by itself) impacts shares returns or volatility a lot in any respect.
ETFs are good for buyers, they usually comprehend it
ETFs enable buyers to purchase diversified and professionally managed exposures to all types of property. Knowledge exhibits they observe underlying portfolios extraordinarily properly, due to good portfolio administration, environment friendly arbitrage and the creation-redemption mechanism.
Spreads are additionally typically low cost — typically cheaper than shopping for a basket of underlying shares — due to an environment friendly community of market makers.
That makes ETFs an affordable and environment friendly device for buyers that additionally minimizes stock-specific dangers.
Briefly, ETFs are good for buyers, they usually comprehend it.
