ETFs are one of the most popular classes of investments on the stock market today. These funds enable investors to easily invest in a broad swath of the market, as well as assets that are often harder to access like real estate and commodities.
While ETFs can be profitable for investors, they’re also money-makers for the firms that create them and the fund managers that oversee them. In this guide, we’ll take a closer look at how ETFs are created and how they make money for both ETF managers and investors.
What is an ETF?
An ETF, or exchange-traded fund, is a basket of assets that trades on a stock exchange. An ETF can hold many different stocks and give you ownership in dozens or even hundreds of companies. Alternatively, ETFs can invest in real estate, commodities, bonds, or even options.
When you buy a share of an ETF, you have a stake in everything inside the ETF’s portfolio.
How are ETFs Created?
ETFs are created when a prospective fund manager, known as a sponsor, applies to the SEC to create a new fund. The sponsor must then establish a partnership with a market maker or investment firm, which has the power to create and distribute shares of the newly formed ETF. In many cases, the sponsor is a fund manager at an investment firm, so the sponsor and share-distributing firm are the same organization.
The ETF manager then borrows stock shares from the investment firm to create the underlying basket of assets that make up the fund. The ETF itself is then subdivided into shares, and these shares are returned to the investment firm to repay the borrowed shares. At this point, the firm can sell the ETF shares to the public through the stock market.
Although this process is somewhat complicated, it ensures that ETF are valued according to supply and demand on the open market. It also keeps ETF’s share prices in line with the relative values of the underlying assets that make up the fund.
Actively Managed vs. Passively Managed ETFs
There are two different types of ETFs: actively managed ETFs and passively managed ETFs.
In an actively managed ETF, the fund manager plays a large role in deciding every single day what is and what is not in the fund. That is, the fund manager can frequently increase the relative weight of one stock inside the fund, drop a stock from the fund, or add a new stock from the fund in response to market conditions. Actively managed ETFs can also short stocks, buy on margin, or rotate from one market sector to another.
The goal of an actively managed ETF is to outperform “the market” – typically, the S&P 500 or an industry-specific benchmark.
Passively managed ETFs, on the other hand, take a much more hands-off approach to investing. Typically, the fund is set up to mirror an index like the S&P 500 or another industry benchmark index. The holdings in the fund are updated quarterly to reflect changes in the index it’s tracking, but more frequent buying and selling activity inside the ETF is highly uncommon.
The idea behind passive ETFs is to give investors the ability to buy holdings that represent an entire index or market sector in a single trade.
How Do ETF Managers Make Money?
ETFs take a lot of work and money to create and maintain. So, how do ETFs make money for their managers and the investment firms that stand behind them?
The main way is by charging a management fee, also known as an expense ratio. The expense ratio describes the percentage of every investor’s investment in an ETF that is taken as a fee. It can range from 0 to over 10%. Passively managed ETFs tend to have low expense ratios – typically 1% or less – while actively managed ETFs can have expense ratios of several percent.
It’s possible to calculate roughly how much revenue an ETF brings in by multiplying its expense ratio by its total assets under management.
Some ETFs also make money by lending out the underlying shares in the fund to short sellers. Depending on how in-demand the shares are, this can generate a significant amount of revenue. Some ETFs share this revenue as dividends to investors, but most keep revenue from lending shares as profits for the fund manager and firm.
How Do Investors Make Money with ETFs?
Investors in an ETF make money in the same way as from stocks – through dividends and price appreciation.
If there are any dividend-paying stocks inside the fund, those dividends are distributed to investors in proportion to the number of shares of the ETF you hold. The share price of the ETF itself increases and decreases over time to reflect the total value of the underlying assets. So, if the stocks inside an ETF appreciate, the ETF itself appreciates and the value of your investment increases.
Conclusion
ETFs are a popular instrument that enable you to invest in a wide range of stocks or other assets with a single purchase. ETFs can make money for investors through price appreciation and dividend payouts. These funds also make money for fund managers and investment firms through management fees and share lending to short sellers.
