Have you ever wondered why ETF investing became popular and why it works? In this post, I answer exactly these questions. The amount of cash invested in ETFs globally ballooned to 10 trillion dollars over the past 20 years. Let’s look at how ETFs work.

How ETFs Work

Any ETF starts with its ETF sponsor. An ETF sponsor is an issuer and fund manager that administers and promotes its ETF. The ETF sponsor creates a trust company that will hold stocks from the underlying index. Next, the sponsor selects an index to track, such as the S&P 500 or Nasdaq 100. 

The following step is the creation of ETF shares. The ETF sponsor contracts with a broker-dealer to create ETF shares on its behalf. These broker-dealers are large financial institutions called authorized participants (APs).  Their role is to regulate the supply of ETF’s shares.

The ETF creation occurs in the primary market. Think of primary market as a marketplace where shares are sold for the first time. The secondary market is where investors trade securities on stock exchanges. 

First, authorized participants buy securities with proper weights to mimic the ETF’s underlying index. The total value of assembled securities is measured in ETF creation units. The typical creation unit has 50,000 ETF shares. Thus, the authorized participants must buy enough securities to support 50,000 ETF shares for one ETF creation unit.

Then, authorized participants deliver the underlying stocks to the ETF sponsor. Next, the ETF sponsor issues and delivers new ETF shares to the authorized participants in the primary market. Later, these new ETF shares are introduced into the secondary market. This is where any investor can buy or sell them.

The redemption is just the reverse of the ETF unit creation process.

Why ETFs Became So Popular?

So, why do ETFs enjoy such a wide popularity? Let’s unpack the reasons behind it.

1. Liquidity and Trading Flexibility

Reason number one is liquidity and trading flexibility. Unlike index or mutual funds, ETF shares are traded like any other stock.  Conversely, you can trade shares of open-end mutual funds only after the market closes. 

It is true that buying or selling at the end of the day is okay for most long-term investors. But, many people need more flexibility than that. Moreover, you can place limit orders on ETFs or sell them short. You can trade ETFs options or use margin on them. It is not exactly a good thing for the long-term performance. But, many market participants prefer this flexibility to rigidity of mutual or index funds.

2. Lower Costs

Reason number two is lower cost.  Compared to mutual funds, ETFs do not incur many client service-related expenses. They do not have to handle investor calls and send reports to shareholders. ETFs also do not charge various redemption and load fees that mutual funds are notorious for.

3. Tax Benefits

The third reason is tax efficiency. Investors pay capital gain taxes only when they sell their ETF shares. So, there is a full control of timing for capital gain taxes. Conversely, mutual funds can pass their capital gains to investors from time to time. Often, many investors get year-end tax surprises from their mutual funds.

4. Diversified Offerings

Diversification is my final reason number four. Of course, diversification is not unique to ETFs. Similar to mutual funds, ETFs let you get exposure to a diversified basket of stocks. In this case, your fortunes are not tied to a few stocks. All this has a major psychological implication. As your ETF holdings go down in price, you are less likely to sell.

Conversely, what if your portfolio is based on your stock pickings? Then, you may freak out thinking you got it all wrong and sell everything. Selling at the bottom is the worst thing and it happens often. For most people who have no time for stock research, ETF investing is the best and easiest way to go.

Besides, ETFs allow you to invest in a wide variety of portfolios. These include many sectors, industries, international equities and bonds. Investors can diversify portfolios with a click of a button during trading hours.

Investors Takeaways on ETF Investing

On a final note, it is almost always a good idea to invest in ETFs tracking some broad stock market index. The S&P 500 comes to mind. Or, if you have at least 10-20 years to wait, consider ETFs tracking Nasdaq 100.

Investing in ETFs tracking broad stock market index is like momentum investing. What do I mean by that? Take any major stock index, such as the S&P 500 index. The S&P 500 selects stocks based on market cap, financial performance and liquidity.

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If a certain company underperforms, the S&P 500 committee will drop it from the index. This approach mimics momentum strategy to some extent. It amplifies strong performance and suppresses weak returns.