Exchange-Traded Funds (ETFs)
An Exchange-Traded Fund (ETF) is an investment vehicle that tracks an underlying index, commodity, sector, or asset class while trading on exchanges like individual stocks. ETFs combine the diversification benefits of mutual funds with the trading flexibility of stocks, offering investors real-time pricing and intraday liquidity.
How ETFs work
ETFs operate through a unique creation/redemption mechanism that helps maintain their market price close to the net asset value (NAV) of their underlying holdings. This process involves:
- Creation - Authorized Participants (APs) deliver a basket of securities to the ETF issuer in exchange for ETF shares
- Trading - Investors buy and sell ETF shares on exchanges through their brokerage accounts
- Redemption - APs can exchange ETF shares back for the underlying securities
Market making and liquidity
Market makers play a crucial role in ETF trading by:
- Providing continuous bid-ask quotes
- Facilitating price discovery
- Managing inventory risk
- Arbitraging price discrepancies between the ETF and its underlying assets
The bid-ask spread of an ETF is influenced by:
- Trading volume
- Underlying asset liquidity
- Creation/redemption costs
- Market volatility
ETF pricing and valuation
ETF pricing involves several key metrics:
- Intraday Indicative Value (IIV) - Updated every 15 seconds during trading hours
- Net Asset Value (NAV) - Calculated at market close
- Market Price - Current trading price on the exchange
- Premium/Discount - Difference between market price and NAV
Next generation time-series database
QuestDB is an open-source time-series database optimized for market and heavy industry data. Built from scratch in Java and C++, it offers high-throughput ingestion and fast SQL queries with time-series extensions.
Trading characteristics
ETFs share many characteristics with stocks:
- Trade on exchanges during market hours
- Support limit and market orders
- Allow short selling
- Have options available on many funds
- Enable intraday trading
Risk considerations
Key risks associated with ETF trading include:
- Tracking error relative to the underlying index
- Market liquidity risk during stressed conditions
- Counterparty risk in synthetic ETFs
- Trading costs and spreads
- Market impact during large trades
Applications in modern markets
ETFs serve multiple purposes in today's markets:
- Core portfolio holdings
- Tactical asset allocation
- Risk management
- Market access to specific sectors or regions
- Cross-asset trading strategies
- Liquidity management
Market impact and execution
When trading large ETF positions, considerations include:
- Block trading capabilities
- Use of algorithmic execution strategies
- Impact on underlying securities
- Creation/redemption arbitrage
- Time zone differences for international ETFs
ETFs have transformed modern investing by providing efficient, transparent, and cost-effective access to diverse asset classes while maintaining the flexibility of exchange-traded securities.