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.
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.
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.
Perhaps the most significant difference between stocks and ETFs is that ETFs allow an investor to get a diversified exposure to an industry, sector, or 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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