ETF Academy – What are Exchange Traded Funds (ETFs)?

• An Exchange Traded Fund (ETF) is an investment fund that holds multiple underlying assets and can be traded on a stock exchange, like an individual stock.
• ETFs aim to replicate an index (such as the S&P 500 or the Nasdaq-100) as closely as possible in order to reflect its performance and provide returns.
• ETFs cover a broad range of asset classes, including equities, fixed income, money markets, currencies, commodities, alternatives, and a combination out of these called multi-asset.
• ETFs can give exposure to specific markets, countries, regions, sectors, themes or to different investment strategies.

Exchange Traded Funds (ETFs) are traded on stock exchanges like shares. This means you can buy and sell them at any time during trading hours. By comparison, typical mutual funds are only traded once a day through the investment company.

An index is used to track the price performance of securities grouped in a hypothetical portfolio that represents a specific market or segment of a market. An index uses a standardized metric and methodology.

Exchange Traded Funds and Mutual Funds both pool money from investors to buy a mix of stocks, bonds, or other investment opportunities. Mutual Funds are usually actively managed by a portfolio manager who aims to buy or sell certain securities in a bid for outperformance. Unlike a traditional active mutual fund, a passive ETF does not need active management, as it aims to replicate an index as closely as possible to reflect its performance and provide returns. Index-tracking ETFs are usually cheaper than Mutual Funds because they require less active management and incur lower fees. ETFs are traded on a stock exchange throughout the market day, while Mutual Funds trade only once daily, after the market closes.

Exchange Traded Funds can offer compelling benefits in terms of diversification, asset allocation, and low costs.

• Diversification: ETFs allow for diversification because they offer access to a wide range of stocks, bonds, commodities, and currencies.
• Asset allocation: Owning ETFs can complement and augment the other building blocks of your portfolio—whether that is cash or cash equivalents, individual securities (equities or fixed income), or alternative investments (e.g., private equity, hedge funds, real estate, etc.).
• Low costs: Most ETFs have historically been index funds and not actively managed funds. As index funds generally don’t employ a portfolio manager applying stock picking strategies to try to outperform the market, they offer lower management fees than active ones.
• Transparency: As ETFs usually track an index which includes a fixed list of securities, you can see at any time which individual stocks or bonds are included in an ETF and how they are distributed across sectors and countries.
• Accessibility: ETF shares provide access to a wide range of underlying assets at once and they are bought and sold like shares on stock exchanges. This eliminates the need for physical handling or specialized infrastructure. 

Most ETFs have historically been index funds and not actively managed funds. Index funds generally have lower management fees than active funds, as they don’t employ a portfolio manager applying stock picking strategies to try to outperform the market. Expense ratios can range from as low as 0.03% for some passively managed ETFs to over 1% for actively managed or specialized ETFs. For active ETFs, 0.5% to 0.75% is considered to be around the average^[1]. To use a simplified example, if you invest $10,000 to buy shares of an ETF with a 0.10% management expense ratio, you would pay $10 to the fund provider each year.

ETFs exist for probably every asset class that you might consider investing in, which can then be further categorized by investment style, sector, strategy, or country/region. 

ETF Asset classes include:

• Equities
• Fixed Income
• Commodities
• Money Market
• Currencies
• Multi-Asset
• Alternatives

You can choose from passive and active exchange traded funds.

Passive ETFs buy and hold a basket of securities, which are typically representative of an index, sector, or country. Unlike a traditional active mutual fund, a passive ETF does not have a portfolio manager who aims to buy certain securities (and avoid others) in a quest for outperformance. Passive ETFs often offer very low fees, as the fund provider doesn’t need to maintain teams of analysts and portfolio managers.

While passive funds still dominate the ETF space, there is now increasing access to actively managed exchange traded funds. These function in the same way as traditional (i.e., passive) ETFs, but have a professional portfolio manager at the helm buying and selling in a bid to outperform an index or other benchmark. Active ETFs do tend to come with somewhat higher fees, but they also have the potential of outperforming their benchmark and are usually not as expensive as traditional active mutual funds. 

A physical ETF replicates the underlying index by buying all or part of the securities  within that index. Some physical ETFs will only buy a representative sample of securities from a market. This may be appropriate when a chosen index is too large, or the underlying markets are too illiquid, to own every single stock.

A synthetic ETF does not buy any shares in the companies listed in the index or sector it is tracking. Instead, the ETF tracks the performance of the target index by entering into a contract with a counterparty, typically an investment bank, to create a synthetic replica of the index through a financial derivative product, usually through a swap agreement.  In a swap, the counterparty (usually an investment bank) promises to pay the returns on the index to the fund. This type of arrangement, however, does expose the fund to counterparty risk, which can be limited through collateralizing the swap agreement. 

The main difference between distributing and accumulating ETFs is that a distributing ETF pays out dividends to investors on a periodic basis, whereas accumulating ETFs reinvest the dividends and interest into purchasing more fund units.

Distributing ETFs are more suitable if you are seeking a steady income stream, while accumulating ETFs makes sense if you are seeking capital appreciation over the long term.

You should consider several factors when measuring an ETF’s performance:

1. Compare it to its benchmark: For a passive ETF that aims to track the performance of a specific index, determine how much it deviates from its benchmark. For an active ETF that seeks to outperform an index, track its relative over- or underperformance against this benchmark.
2. Compare it to its peer group: Determine how an ETF performs against other funds that maintain similar investment objectives and are in the same investment category. A fund service such as Morningstar provides this information.
3. Add up the fees: Fees and commissions will reduce your ETF returns. These expenses are incorporated into an ETF’s published rate of return.

ETF companies charge investors several expenses associated with the operation of an ETF, which reduces its value. Each ETF has an expense ratio, which is expressed as an annual percentage of the total assets under management (AUM) and is deducted from the ETF’s net asset value (NAV). An expense ratio encompasses several components, including:

1. Management fee: The fee charged for the professional management of the fund.
2. Operating expenses: Expenses covering administrative costs, custody fees, and legal fees.
3. Trading costs: Costs associated with buying and selling the underlying assets that make up the fund.
4. Taxes: ETFs may also be subject to taxes including, interest, dividend, and capital gains taxes, which are passed on to investors.

Most ETFs have historically been passively managed funds that follow an index and are traded only as needed. As a result, index funds generally have lower management fees. Most mutual funds incur higher expenses, as they are actively managed, employing a portfolio manager applying stock picking strategies to try to outperform their benchmark.

Additionally, actively managed ETFs usually have lower management fees than their mutual fund counterparts. Some expenses found in mutual funds are absent in ETFs, such as 12b-1 fees, which are marketing fees that can be charged to the fund.

ETF fees are not deducted or withdrawn directly from your account. The fees are taken from the fund’s assets, subtracted from the NAV, and are accrued daily. The fees are typically deducted from fund assets on a monthly basis.

Returns obviously matter, but what really matters are after-tax returns. Fortunately, exchange traded funds are designed to help minimize the taxes paid by investors holding the ETF. 

Without going into too many details, ETFs can engage in ‘in kind’ transactions for their underlying securities, which avoid the realization of capital gains. This leads to lower capital gains taxes payable for those who hold an ETF in their portfolio. Trading activity within the ETF often will not create any tax implications.

You will still realize capital gains for the increase in an ETF’s purchase price vs. its sale price. Generally, profits from the sale of ETFs held for under a year are taxed as short-term capital gains. ETFs held for longer than a year are considered long-term gains and taxed at a lower rate.

For income generating ETFs, ordinary dividends are taxed at the same rate as regular income, which is a function of your tax bracket. Qualified dividends are taxed at a lower capital gains rate. For bond ETFs, payments from bonds and bond funds are taxed as regular income, similar to ordinary dividends from stock ETFs.

Exchange traded funds have two mechanisms that contribute to their price efficiency. 

First, each ETF has one or more designated Authorized Participants (AP). These are typically brokerage firms or other trading companies. Authorized Participants may deal both in a given ETF, as well as that ETF’s underlying assets—creating and redeeming units of a fund in the process. If the market price of an ETF is trading at a discount to its Net Asset Value (NAV), an Authorized Participant can deliver units of the ETF to the fund’s provider, taking the ETF’s basket of securities in return. 

On the flip side, if an ETF is trading at a premium to its NAV, an AP can profit by doing the reverse: Buying securities and delivering them to the fund provider in exchange for ETF units. This kind of arbitrage is profitable for the Authorized Participant and brings the market price of a fund in line with its value. 

A crucial benefit of ETFs is their transparency. In other words, you know what you’re buying, and you know what you’re selling. ETFs differ in the amount of transparency they provide, but in both cases, there is sufficient disclosure for you to make an informed decision. 

Fully transparent ETFs publish their complete list of holdings daily. That means the market knows at the end of each trading day which securities an ETF owns—and exactly in what quantity. 

Semi-transparent ETFs, on the other hand, shield some level of detail to protect their investment process. To facilitate transparency, these funds publish what is known as an indicative NAV (iNAV). Usually updated every 15 seconds throughout the trading day, an indicative NAV tells the market what a fund’s underlying holdings are worth. Semi-transparent ETFs also publish a proxy basket for Market Makers: While not a fund’s actual portfolio holdings, this basket is designed to be sufficiently representative to encourage trading firms to keep providing liquidity to the market.

After a buyer places an order for an ETF, there are multiple ways traders can source the shares for that end-investor’s account. ETF traders can operate in two markets: on the secondary market, which involves buying and selling shares that currently exist on an exchange, or on the primary market, where ETF share creation and redemption orders take place. 

The creation order process results in new shares of the ETF being made from an ETF’s individual holdings and added to the previously existing ETF shares outstanding on the exchange. Conversely, the redemption order process breaks down existing ETF shares into their individual components and removes them from the pool of ETF shares trading on the exchange.

ETFs and mutual funds similarly can create and redeem shares directly with the issuer, but ETFs unlock an additional type of ability to trade shares by being listed on the exchange. The amount of ETF shares being bought or sold on the exchange is an ETF’s secondary market trading volume, or average daily volume (ADV). 

A security’s average exchange volume is a good barometer for the amount that can be bought and sold on the exchange without significantly moving the price of the security. The primary and secondary markets comprise ETFs’ layers of liquidity (availability to buy and sell): the first liquidity layer emerging from preexisting ETF shares’ trading volume, and the second liquidity layer arising from the ability to create or redeem ETF shares. 

While every mutual fund transaction results in the purchase or sale of the underlying holdings of the fund, only creations and redemptions result in a change to shares outstanding, and therefore assets under management (AUM) for an ETF. Due to many ETF transactions taking place in the secondary market, ETFs buy or sell their underlying holdings less frequently than mutual funds, impacting the underlying securities less often.

A second layer of price efficiency in ETFs arises due to the actions of what are known as Market Makers. Market Makers are trading firms designated to provide liquidity when required. These firms post bid and ask quotes throughout the trading day, giving prospective buyers and sellers the ability to trade in an ETF. As with Authorized Participants, Market Makers can help arbitrage away any significant premium or discount in an ETF relative to its underlying NAV—buying if an ETF is trading at a discount and selling if it’s trading at a premium.

Every trading day, many illiquid ETFs trade in quantities that are multiple days of their average daily volume (ADV), and at prices at or near their net asset value (NAV). 

ETF liquidity can be much deeper and much more dynamic than stock liquidity. An ETF’s liquidity is predominantly determined by the liquidity of its underlying individual securities, rather than by the size of its assets or by trading volume.

Many ETFs that feature low trading volume also have the underlying basket of securities that are very liquid. This enables market makers to provide liquidity and make a market both in large size and with a tight bid/ask spread. 

This process is often accomplished by a market mechanism know as a Request for Quote (RFQ), where an investment manager signals their intention to buy or sell an ETF in large size. The RFQ is usually sent electronically to market makers and allows the manager to compare quotes from multiple liquidity sources to ensure they are trading at the best available price.

Like other investments, the primary risk in investing in an ETF is market risk, that adverse market conditions can result in the decline of the value of the fund. The degree of market risk is a function of the underlying assets that an ETF tracks.

There are also some unique risks to ETFs that should be considered. You should monitor the tracking error versus the benchmark that your ETF might experience. This could negatively impact the performance of your investment. 

Additionally, you need to understand the liquidity – how easy or difficult it is to buy or sell a security without significantly impacting its price. 

Another factor you should consider is the ETF holdings - what exactly is under the hood of the ETF that you own. Do the portfolio holdings match with the fund’s investment objective? Is there single stock concentration risk?

And always consider the fund's investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the fund's prospectus.

Like many investments, not all ETF launches are successful. It is not unusual for an ETF issuer to close an ETF if it does not attract sufficient assets to make the product viable. When this action does occur, this is how the process plays out:

1. An announcement is made one to four weeks before the ETF closing date, enabling you to sell your shares before trading is halted.
2. Once the ETF is closed, it is delisted, and all trading is stopped.
3. When the ETF liquidation begins, the fund has about two weeks to sell its holdings and the cash is paid out to you or credited to your account.

The assets of the underlying ETF belong exclusively to their investors and are protected in the event of an ETF provider’s bankruptcy. They are legally separate from the assets of the fund company, as they are usually held by an independent third party known as a Custodian. The Custodian has been appointed by the ETF issuer but is independent from the same organization. In the unlikely event an ETF issuer becomes insolvent, the issuer's creditors will be unable to access the assets that form the underlying ETF.

There are numerous ETFs and ETF strategies available to build a diversified portfolio. 

1. Define your investment objective: Are you saving for retirement, a new home, or your children’s education? This decision will enable you to define your time horizon, which will impact step #2.
2. Determine your risk tolerance: Risk tolerance is a measure of how much market volatility that you are willing take on in exchange for potential long-term growth. The general rule of thumb is that the longer your money will be invested, the more risk that you may be able to accept.
3. Determine your asset allocation: Know your time horizon and risk tolerance and determine the mix of assets (stocks, bonds, cash, commodities, etc.) and their percentage allocation to each in your portfolio.
4. Implement your Investment Strategy: Once you have established your asset allocation, choose the ETFs that would make the best fit. Many advisors and brokers can provide you with the analytical tools to choose the appropriate ETFs that could best align with your investment objectives.
5. Monitor Performance: On a regular basis, review your portfolio to determine if it is achieving your investment objectives. Do not excessively trade as a reaction to short-term market gyrations. Consider rebalancing no more than quarterly.

ETFs are easy to access. Anyone with a brokerage account (whether it’s self-directed or through an advisor) can buy and sell ETFs. Usually, with online trading, this can be done with the click of a few buttons. Additionally, many online brokers now offer zero-fee commission trading on ETFs.

Additionally, many brokers now maintain a team of ETF specialists who are eager to assist you determine the ETFs and even offer model ETF portfolios that best fit your investment objectives. 

Exchange traded funds are accessible in another way as well: there’s no minimum purchase. This makes them ideal for individuals who are just starting to build a portfolio. Mutual funds, on the other hand, typically require a minimum investment.

1. Transparency: Most ETFs are fully transparent, meaning that they publish their holdings daily. This feature enables you to have a clear view of the specific assets held within the ETF.
2. Accessibility: ETFs are easy to trade, either online or through your broker, with no minimum purchase.
3. Flexibility: ETFs can be bought or sold any time during the trading day, enabling the ability to respond to market changes as they happen. Additionally, some online brokers now offer 24-hour ETF trading capabilities.
4. Dividend reinvestment: ETFs have the ability to reinvest dividends automatically.

There is no ideal time to start investing, as it is difficult to time the market. If you start investing on a regular basis (like monthly), the advantage is that you don't have to worry too much about the perfect time to enter the stock market.

In declining markets, for example in times of crisis, prices are usually lower, and thus more ETF shares can be purchased for the monthly deposit amount. 

In rising markets with potentially higher prices, correspondingly fewer ETF units are purchased for the monthly amount.

In the long term, this results in an average cost effect for the prices at which you bought the ETF units.

This decision is up to each investor. With exchange traded funds, the choice is simple – investors can buy as many or few shares as they want, as there is no minimum purchase. This makes ETFs ideal for individuals who are just starting to build a portfolio. 

Xtrackers by DWS is a global provider of passive and active solutions with a track record going back over 20 years. We provide investors with innovation, access, and value through a broad range of cost-effective, high-quality US-listed exchange-traded funds (ETFs) across all major asset classes – equities, fixed income, and commodities. 

Xtrackers ETFs provide numerous building blocks for traditional investment strategies, FX-hedged equities, mainland China equities, sustainability, dividends and factors, high-yield, as well as innovative products on thematic investments and growth trends of the future.

With Xtrackers ETFs, it is possible to achieve exposure to a diversified portfolio of securities in one instant transaction in the same way as trading any other security listed on a stock exchange. The key benefits of Xtrackers ETFs can be summarized in three words – efficient, transparent, flexible.

Low Fees – Almost all Xtrackers ETFs are passive index tracking instruments with low annual management fees and expense ratios compared to traditional fund products.

Continuous Pricing: Xtrackers ETFs trade on a stock exchange with various market makers providing liquidity during exchange trading hours.

iNAV: The intra-day price of Xtrackers ETFs can be followed through the iNAV (indicative Net Asset Value), which is calculated and disseminated regularly during exchange trading hours via Reuters or the respective exchange websites.

Holdings: Xtrackers ETF holdings are fully disclosed on a daily basis, giving you the ability to see exactly what is in your portfolio.

Intra-day trading: Xtrackers ETFs can be bought or sold on the stock exchange during normal trading hours in the same way as any exchange-listed security.

Trading size flexibility: unlike other instruments such as futures, Xtrackers ETFs can be traded in small lot sizes.

Multiple investment applications: Xtrackers ETFs can be used by investors for a variety of investment strategies, ranging from using them as an intra-day trading tool to forming the basis of long-term asset allocation decisions.

DWS Group (DWS) with EUR 1,012bn of assets under management (as of 31 December 2024) aspires to be one of the world's leading asset managers. Building on more than 60 years of experience, it has a reputation for excellence in Germany, Europe, the Americas, and Asia. DWS is recognized by clients globally as a trusted source for integrated investment solutions, stability, and innovation across a full spectrum of investment disciplines.

DWS offers individuals and institutions access to their strong investment capabilities across all major liquid and illiquid asset classes as well as solutions aligned to growth trends. DWS’s diverse expertise in Active, Passive, and Alternative asset management – as well as deep environmental, social and governance focus – complement each other when creating targeted solutions for our clients. Our expertise and on-the-ground knowledge of our economists, research analysts and investment professionals are brought together in one consistent global CIO View, giving strategic guidance to our investment approach. 

DWS wants to innovate and shape the future of investing. We understand that, both as a corporate as well as a trusted advisor to our clients, we have a crucial role in helping to navigate the transition to a more sustainable future. With approximately 4,700 employees in offices all over the world, we are local while being one global team. We are committed to acting on behalf of our clients and investing with their best interests at heart so that they can reach their financial goals, no matter what the future holds. With our entrepreneurial, collaborative spirit, we work every day to deliver outstanding investment results, in both good and challenging times to build the best foundation for our clients’ financial future.

Discover our broad range of ETFs