What is an ETF? - Definition & Arbitrage

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Exchange Traded Funds, or ETFs, have become a popular alternative to mutual funds for investors. Let's dig deeper into ETFs and the investment opportunities they create.

What is an ETF?

Drew has one of those problems that everyone wants to have. He just inherited a sum of money from his late uncle, and he doesn't know what to do with it!

Just putting it in the bank wouldn't earn much interest, and he is young enough to take a chance on the stock market. He knows about mutual funds because his father invested in those, but someone at work told him ETFs are better. So just what is an ETF?

First let's review what a stock index is. An index is a collection of stocks representing a common theme. The Dow Jones Industrial Average is an index most people have heard of. An exchange traded fund (ETF) is a marketable security that tracks the price movements of an index, commodity or other basket of assets. An ETF is able to replicate the price movements of an index because it owns shares of the stocks that make up that index.

There are literally thousands of exchange traded funds out there that track the price movements of many financial indexes and asset classes. So when the price of the underlying index or assets goes up 5%, the ETF that tracks it also goes up 5%.

Not all ETFs track stock indexes. Some also track agricultural commodity prices, or spot prices for assets like gold and precious metals or oil.

Why Investors buy Them

The biggest ETFs replicate the price movements of the major stock market averages
Stock prices

Many exchange traded funds replicate the price movements of major financial indexes. The biggest ETFs track the major stock market indexes, like the Dow Jones Industrial Average and the Standard and Poor's 500.

Investors seeking to replicate general market returns can accomplish their objective with an ETF. Indexes also track many different sectors of the economy like technology or transportation, and there are ETFs that track their price movements.

Drew is getting excited by what he is finding out. He loves technology and would like to invest some of that money in technology companies. Instead of buying shares of ten or so technology stocks and paying the commissions, all he needs to do is buy shares in one ETF that tracks a technology stock index and he can share in the gains when the stocks go up!

Advantages of ETFs over Mutual Funds

Drew is also finding out why ETFs are better than mutual funds.

  • ETFs trade like common stocks; they are listed on the major exchanges. Investors have the power to sell short and buy on margin that aren't available in mutual fund investments.
  • Prices of an ETF change instantly just like a stock price. This is an advantage over mutual funds whose prices only change at the end of each trading day when the net asset value is calculated.
  • You can own an ETF by buying as little as one share. Mutual Funds usually have a minimum investment amount, typically $3,000.
  • ETFs have lower expense ratios than mutual funds, so the commission and fees for ETFs are much lower.

ETFs and Trading Opportunities

ETFs can create arbitrage opportunities for professional traders. Arbitrage is the practice of buying an asset cheaply in one market and selling the same asset for a higher price in another.

Jenny works at the trading desk at a major bank. She has several computer terminals on her desk. One of the things she follows on them is the prices of the 30 stocks that make up the Dow Jones Industrials and the ETF that tracks them.

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