Many small investors don’t know yet what ETFs are, how they’re different from mutual funds, or what their advantages are.
The best way to understand ETFs is to start with the same concept that ETF inventor Nathan Most did — warehouse receipts.
Many years ago money consisted of gold and silver. That was fine for people who owned only a few coins, but it was a practical problem for the wealthy. It was neither safe nor convenient to walk around carrying gold bars, especially when they just needed to buy some chickens at the local market.
Therefore enterprising people created secure warehouses to hold gold, silver, and other valuables. If you owned ten troy ounces of gold you’d place it with the warehouse and the warehouse owner issued you a receipt. The bearer of the receipt could claim the gold whenever they wished.
Because the paper receipt was easy to carry around, people started trading these receipts for the goods they wanted to buy. Merchants accepted them as payment because they knew they were backed by gold in the warehouse.
In effect this was the origin of gold and silver backed paper currencies. Nathan Most applied the concept to financial securities.
An ETF management company buys a basket of stocks or bonds. In effect they’re warehousing those securities. The company then issues stock in itself as an IPO. Its company ownership shares act as the receipts for the financial securities the company owns. Investors can buy and sell their shares in the ETF company in the secondary market through brokers just as they can buy and sell shares of IBM. The only assets backing up those ETF company shares are its financial securities.
Because of this structure, when you own shares in an ETF company you do not have to pay capital gains taxes unless and until you sell those shares. With ordinary mutual funds you often are forced to pay capital gains taxes because the manager sold stocks during the year. This is true even if the fund’s share value has gone down.
The financial securities owned by the ETF company generally replicate an index. The company buys and sells additional securities only if needed because of changes in the index.
This means that, unlike both actively traded open and closed-end mutual funds, ETF investors know exactly what they’re getting for their money. It also keeps ETF trading costs much lower than those of actively traded mutual funds, saving investors money.
Most came up with a system of assigning Authorized Participants to each ETF. These people buy and sell the ETF fund’s underlying securities to keep their share prices in line with the market prices of those securities. This avoids the common situation with closed-end mutual funds where the fund’s shares are trading at a price either below or above the market price of the securities it owns.
Therefore, ETFs give investors the best of all worlds. They get the diversification mutual fund buyers seek, but at a much lower price and with transparency. Plus, ETF share owners don’t have to pay any capital gains taxes unless they sell shares.
Posted in Exchange Traded Funds | 
Tags: Company Shares, Etf, Few Coins, Financial Securities, Gold Bars, Inventor, Paper Currencies, Shar