What are exchange-traded funds?

An introduction to the benefits of ETFs and the key participants needed for the exchange process.

Tags: ETFs, Funds
Published: September 03, 2020

Exchange-traded funds (ETFs), or funds that can be traded on stock exchanges, present an attractive and advantageous alternative to traditional mutual funds. Because of their benefits, they’ve become a popular option for a wide range of investors. This article will provide an introductory look at ETFs, highlight their key advantages, explain the roles of the parties involved and look at their potential into the future. 

Exchange-traded funds (ETFs) are similar to mutual funds in many ways—with one key difference. As the name implies, ETFs give investors the ability to buy and sell shares on a stock exchange. The most popular ETFs are passive, which means they utilize index tracking. Passive ETFs invest in a basket of securities that replicate the performance of the index the fund tracks.

 

Advantages of ETFs

ETFs offer several notable advantages for investors looking for both long- and short-term solutions. Some of the most significant advantages include:

  • Tax efficiency—whereas mutual funds have serious tax implications, ETFs provide the potential to mitigate capital gains.
  • Transparency—every ETF, whether passive or active, provides complete transparency to its holdings, which can be viewed on an ongoing basis.
  • Flexibility—unlike mutual funds, ETFs can be bought and sold like common stocks during the day on an exchange through a broker.
  • Lower fees—ETF fees are typically lower than fees for mutual fund shares.
  • Higher liquidity—ETFs typically offer higher daily liquidity than mutual fund shares.

 

Authorized participants (APs) and lead market makers (LMMs)

ETFs require two key parties to facilitate the exchange process: authorized participants (APs) and lead market makers (LMMs).

Authorized participants are the capital market’s facilitators of the ETF creation and redemption process. This process is a key feature that distinguishes ETFs from their mutual fund counterparts. An AP’s function in the ETF space is similar to that of a broker-dealer or other financial intermediary in the open-end space. In essence, the ETF distributor and the AP work together to facilitate the creation and redemption of ETF shares.

Lead market makers (LMMs) provide liquidity, per the ETF’s listing exchange requirements, for the ETF shares during regular trading hours. Sometimes, the same firm will serve as both an LMM and an AP based on its internal capabilities. In other cases, these functions fall to separate parties.

 

Growth potential

Because of the benefits they provide, the popularity of ETFs will likely continue to grow. They present an attractive investment option to numerous types of investors. One client, an $8 billion fund family, was reluctant to enter the ETF market for a long period of time. The fund preferred traditional, open-end mutual funds and separately managed accounts (SMAs). However, the fund’s research team recently indicated it saw an overwhelming majority of asset management inflows going toward ETFs. Because of this trend, it expressed a renewed interest in exploring the ETF space.

This is just one of many examples that demonstrate a growing recognition among investors for ETFs and their potential benefits. Based on client feedback and investment trends, all signs indicate the popularity of ETFs is unlikely to diminish anytime soon.

 

Learn more about ETFs and whether they might be right for you. Visit us at usbank.com/globalfundservices or connect with a global fund services expert.
 

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