What are exchange traded funds?

ETFs are much like mutual funds but there are some key differences. ETFs also have sponsors. These sponsors have contractual relationships with authorized participants. These authorized participants are financial institutions like large brokers or banks. They obtain the underlying assets (securities) to create ETF shares. When there are shortages of ETF shares in the market or if the price per ETF share is too low compared to the underlying assets, the authorized participants will step in. By creating more shares in the market or reducing the amount of shares to increase the price per share. This ensures that the ETF share price is always close to the NAV price (Net Asset Value). Authorized participants are also responsible for the securities the ETF sponsor wants to buy or hold. 

Larger ETFs have multiple authorised participants. This increases liquidity. As mentioned before, there are a few types of investment companies:

While mutual funds are open-end, ETFs can also be UITs or closed-end. 

The biggest difference between mutual funds and ETFs is the type of management. ETFs are passively managed while mutual funds are actively managed. This makes a huge difference. A mutual fund is actively buying stocks and other securities over many years while an ETF mostly only follows an index. For example, an ETF that is tracking the S&P 500 only buys stocks from the S&P 500. Meaning whatever result the S&P 500 produced, the ETF will almost have the exact same result.

While ETFs are almost used exclusively as passive investments, there are some ETFs that are actively managed. About 2% of all the ETFs are actively managed. Although the reason is not 100% clear, there are not many actively managed ETFs because of the transparency rules. Actively managed ETFs need to be more transparent about their holdings vs mutual funds. 

It might sound strange that you as an investor can’t exactly see what you are holding. But there is a good reason for that and that is to protect the funds from exposing their stock picking tricks and abilities. If everything was public, you can simply copy the same strategy  or buy the same stocks without having to buy any shares from actively managed ETFs or mutual funds.

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