ETFs continue to grab headlines. But how do they work?

Exchange-traded funds are all the rage. Some analysts predict ETFs are on track to replace traditional mutual funds because they offer so much trading flexibility, not to mention better returns (thanks to lower costs) and capital gains tax-deferral advantages.

ETFs trade fast and often, giving individual investors some of the excitement of tracking a swiftly changing investment – although they are not as volatile as individual stocks.

It gives you something to look at on your phone because the value changes every few minutes, says Mark Cortazzo, senior partner with Macro Consulting Group in Parsippany, New Jersey. However, he adds that simply tracking the activity of the fund shouldn’t change the investment purpose: to park money in a relatively safe growth vehicle. Daily fluctuations shouldn’t distract from long-term planning, he says.

How ETFs work. Both mutual funds and ETFs are comprised of baskets of investments. Usually, the investments in a basket have something in common – they are all stocks of Standard & Poor’s 500 index companies, for example, or a particular type of bond.

But mutual fund shares can be bought and sold only once a day (at 4 p.m. in case you’re timing it). The price of mutual fund shares is based on the net asset value of the investments in the fund basket. That means if other investors in the fund want in or out for reasons unrelated to the market, the fund value can fluctuate – affecting the value of your shares.

ETFs are different in several ways. First, they are traded all day long, which means market demand likely is evened out throughout the day instead of concentrated into that end-of-day trading period, explains Michael Jabara, executive director for Morgan Stanley Wealth Management’s ETF and closed-end fund research team.

But there’s a twist: If a major investor wants in, an investment manager can make new shares in the ETF by depositing a creation unit comprised of the same investments in the existing ETF basket with the fund custodian. The same process works in reverse, he says. An investor can redeem the basket by turning in the ETF shares to the custodian. The key is that the ingredients of the creation unit are identical when the unit is made and when it is redeemed.

It’s a little like bringing your own ingredients to a salad bowl: You put in a specific tomato, increasing the tomatoes for all. Then when you leave, you take that same tomato, so there was no net change in the number of tomatoes.

As well, trading costs to bundle and unbundle the creation units and to trade the ETF shares are handled outside the ETF itself. By contrast, transaction costs associated with investors entering and leaving the fund are a major component of mutual fund expenses.

The ETF structure has you pay the cost that you cause, says Gary Gastineau, founder of ETF Consultants in Bonita Springs, Florida. All the costs of entering and leaving the ETF occur outside the fund – creating, trading and redeeming the shares. It’s a more equitable way of attributing the cost of people getting in and out and inflicting transaction costs. If you’re in and staying in, you shouldn’t have to pay the costs for others who are going in and out, he says.

Those costs can add up. The flow costs for a mutual fund could be 75 basis points a year, Gastineau says. That penalizes the performance of the fund to cover the transaction costs of people going in and out of the fund.

Although ETFs typically do not charge a load to buy in, you will probably pay a commission. If you are making a large trade, there might be a bid/ask spread reflecting the current value, he says.

What you need to know. Like all funds, ETFs are only as good as what they are made of. An ETF is a vehicle. It’s what’s in it that counts, Jabara says.

Net asset value is the term for the actual value of all the items in the basket that make up a particular ETF. To understand the difference in valuation that is introduced with the ETF structure, compare the net asset value to the ETF share price.

In most ETFs, you are less likely to have a capital gains distribution as a current shareholder. When you exit the ETF, you will have to pay capital gains taxes, as you would with any fund. Inside the fund, it’s more efficient typically than the traditional mutual fund, but once you get completely in or out, you do have to pay tax consequences, Cortazzo says.

Many ETFs are tied to economic stock and market indexes. Before buying shares of an indexed ETF, research the index methodology so you understand what it measures and how, advisors recommend. Also research the track record of that index. If it tends to move the markets, it will likely touch off fluctuations in the value, Gastineau says.

As with all investment vehicles, the most important question is not, ‘Should I buy an ETF? But ‘What market sectors do I need to be in and what vehicles are best?’ Jabara says. First come up with your allocation mix, and then figure out what ETFs achieve that, he says.