How do ETFs work?

ETFs are designed and marketed by large financial sponsors such as State Street or Barclays.  Like many mutual funds, ETFs are open ended meaning that they have no fixed number of shares.

As demand for shares picks up, the sponsor sells blocks of shares to a large financial company known as an Authorized Participant or AP. The AP will then make a secondary market on one of the 3 major stock exchanges – that’s where individual investors also participate.

The behind-the-scenes detail is important, as the mechanics are what gives ETFs their tax and performance edge over mutual funds.  For example, because investors redeem mutual fund shares directly from the fund, the manager cannot be fully invested – this practice hurts mutual fund returns and is known as “cash drag”.

If redemptions outpace the money coming into a mutual fund, the manager will need to sell some stocks and pass along any tax obligations to the remaining shareholders – even if they had invested only days earlier.  Capital gains taxes are a big problem for mutual funds. Some experts estimate that taxes hurt mutual fund returns by a full 2% ever year.

ETFs are typically free from capital gains distributions and their associated taxes.  This is because the sponsors deal only with the APs.  If demand for an ETF shrinks, the sponsor simply transfers the stocks to the AP in exchange for the shares and no cash changes hands.