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How ETFs are different than stocks

  • Wiley Global Finance WILEY GLOBAL FINANCE
  • Exchange-Traded Funds
  • Stocks
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One sometimes hears that “ETFs trade just like stocks.” That’s true to a certain extent. ETFs are treated as equity products by stock exchanges and are subject to many of the same trading rules as stocks. But there are important differences that investors should understand.

Product Structures

ETFs have some internal mechanics that make them very different from a typical stock. The most glaring is the fact that ETFs have what is called continuous issuance of shares via the creation and redemption mechanism. This feature enables rapid expansion or redemption of shares outstanding in an ETF and is the main facilitating feature that has enabled ETF volumes and assets to grow. It is this creation and redemption functionality that unlocks all of the underlying liquidity in an ETF, making it accessible to every investor.

Stocks, on the other hand, are issued by a company through an investment bank. While a company can issue stock or buy back stock at any time, generally these changes are infrequent. So, for long periods of time, the amount of shares outstanding in a given stock is constant.

The difference in structure is manifested when stocks and ETFs are traded. When you buy or sell a stock, you generally are trading with a counterparty with a different market view of where the stock is headed. In essence, in a typical stock trade, a bullish viewpoint and a bearish viewpoint come together at a similar price point, enabling a trade to occur.

An ETF trade is different. A large proportion of ETF trades take place between a bullish or bearish investor and a liquidity provider. So instead of buying from another investor with an opposing viewpoint, the investor typically is trading versus a liquidity provider.

High Volume and Low Volume ETFs

A lead market maker (LMM) in an ETF is charged with the responsibility of buying and selling ETF units with investors. The lead market maker does this by buying or selling an equivalent number of the underlying stocks that make up the ETF product.

In higher volume ETFs, there are so many arbitrage participants continually competing with ever-tightening spreads that actual LMMs are not critical to the daily order flow, so they become a smaller percentage of the volume in the market. Alternatively, in the newer, typically lower-volume ETFs, the LMM is important, playing the role of product caretaker, helping these products to grow by providing opposing liquidity against client order flow.

In any investment product, liquidity and the spread between the bid and ask price are important considerations. Generally, the less liquid the instrument, the wider the bid/ask spread. This is true of ETFs and stocks.

Similarities Abound

Although the fundamental structures of a stock and ETF are different, there are important similarities: transaction costs and efficiencies; margin rules; and short selling – these are all virtually identical. In addition, both stocks and ETFs are priced and traded throughout the day and most have options associated with them.

Subtle Differences

Perhaps the most significant difference between stocks and ETFs is that ETFs allow an investor to get a diversified exposure to an industry sector of market. To do the same thing with stocks would require purchasing multiple stocks. Deciding on which stocks to buy and in what quantities can be a daunting task. So for investors who want to express a viewpoint on a particular sector or market, ETFs are probably a more effective vehicle than individual stocks.

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Article copyright 2012 by David J. Abner and Gary L. Gastineau. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange Traded Funds and The Exchange-Traded Funds Manual , Second EditionT with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.
ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. ETFs are subject to management fees and other expenses.
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