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A Primer on Exchange-Traded Fund (ETF) Terminology





This is a post by our regular columnist Clark.

An ETF is a well-known investment vehicle these days; usually, they closely track an index – be it sector or asset class – by holding the same basket of stocks or bonds similar to index (mutual) funds. The difference between ETFs and index funds is that ETFs trade on the stock market and can be bought and sold at anytime during trading hours. So, their price varies based on market conditions similar to individual stocks. This also provides the chance to sell short or buy on margin in a taxable (non-registered) account. These ETFs are usually sold with lower expense ratios than corresponding index funds. However, trading commissions are paid on ETFs, whereas mutual fund units can be bought free of cost. This post will look at some of the key terms associated with ETFs.

Net Asset Value (NAV)

This is the total value of each share of an ETF calculated using the total of its underlying holdings (including cash) minus liabilities and the total number of shares.

NAV = Total net assets of the ETF / Total number of outstanding shares

The market price may be different from the NAV of the ETF since the price may fluctuate depending on market forces (supply and demand).

Market Price

As mentioned above, an ETF’s trade price may vary from its NAV. This is markedly different from an open-end mutual fund where units are bought and sold at their NAV. Nonetheless, most ETFs do trade at prices close to their NAV.

Premium and Discount

Since market forces of supply and demand establish ETF prices, the variations from the NAV are termed as premium and discount.

  • Premium (+) to NAV: An ETF that trades at a price higher than its NAV is available at a premium to its NAV.
  • Discount (-) to NAV: An ETF that trades at a price lower than its NAV is available at a discount to its NAV.

Market Return

This is the total return earned by an investor based on the difference between their average selling price and average buying price minus trading commissions for each.

% Market Return (annualized) = [{(SP - TC) / (BP + TC)} ^ (12/N) – 1] * 100 where,

SP = average sell price

TC = trading commission

BP = average buy price

N = Number of months invested

NAV Return

This is the total return based on the NAV (the same formula above can be used after replacing the market prices with the NAVs) of the ETF at the start and end of the holding period. The NAV return may vary from the market return due to market swings; so, ETF investors should use market return to calculate their total return, except for those who bought creation units.

Creation Unit

A creation unit refers to the least amount of ETF shares (typically, tens of thousands) that can be traded with the fund company directly at NAV. Due to the sheer volume of these trades, only market makers and financial institutions can afford to trade them; the majority of retail investors will have to be content with ETF shares at market prices, traded over a stock exchange.

Open-end fund

This structure is used by various ETF groups including iShares. In this type of structure, the units can be issued and redeemed at any time. However, ETFs do not offer individual shares directly to investors and only issue their shares as creation units. Large institutions and market makers buy these creation units through a group of securities that mirror the ETF’s holdings. After buying these creation units, the market maker splits the unit and sells the individual shares on a stock exchange, thereby enabling retail investors to get a share of the pie.

Closed-end fund

The term “closed” refers to the fact that these types of funds are closed to new investments after the initial capital has been raised for the fund. Thus, an investor is left to purchase these funds from the secondary market (market maker or another investor). Closed-end funds seldom trade near their NAV.

Do you invest in ETFs? Are there more key terms associated with them that one should know?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.





7 Comments, Comment or Ping

  1. 1. Jungle

    Thanks for the primer! I never knew what NAV means.

    Another “part two” could be about how ETFs are changing and coming out with new products, such as leveraged ETFs, swap agreements, etc.

  2. A little off topic, but on CNBC yesterday I heard there are 1000 ETFs that are waiting for SEC approval to launch. Everything from small individual country ETFs to new commodity ones are on the table. To put it in context, there are currently 700 ETFs trading on U.S. markets right now.

    So yeah, ETFs aren’t going away anytime soon.

  3. 3. Larry

    maybe an explaining of ETF management expense ratios. A Claymore on lists Management Fees 0.50 % and Management Expense Ratio of 0.53 %. I noticed say something about HST also. Are these charges additive ie: 0.50%+0.53% = 1.03%?

  4. 4. Clark

    Thanks for the comments.

    @Jungle, @Larry: I’ll write a “Part 2″ based on your suggestions.

  5. 5. JFG

    I find that people are complicating things. ETF’s are there to make things easier for you. I have never looked at them the way you describe them. And, in all honesty, I don’t care. They are part of my buy and hold. I do re calibrate on a yearly basis (if warranted), but apart from that, they are a no brainer… AS LONG AS THEY ACTUALLY FOLLOW THE MARKET AND NOT MANAGED.

    I’ve had ETF’s for over 15 years. I buy, I hold, they grow, I look at them once a year.

  6. ETFs are quickly becoming “the new mutual fund” IMO.

    Personally, I’m avoiding all ETFs that don’t track the index.

    Like JFG, I buy, hold and like a small tree in the backyard, I watch it grow.

  7. Excellent post, Clark. Additional suggestions for follow-on article(s) could be a discussion of index-fund / ETF “tracking errors”, and/or the difference between passive-management and active management. I’m so glad you mentioned the bit about being able to buy small amounts of mutual funds without transaction fees. Those fees can really add up, especially for investors of modest means where the fee is a much higher percentage relative to their investment. There are cheap ways of getting ETFs; sharebuilder.com is one way that I’m aware of. Last thing I can think of worth mentioning is that Mutual Funds are priced only once per day, where as ETF prices are continuously adjusted. Clever readers will immediately grasp the implication that one could theoretically attempt arbitrage intra-day when there is a significant change in a mutual fund’s underlying asset base. The frowned upon tactic is called “mutual fund timing”.

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