For those investors who recognize that professional money managers rarely beat the index, investing in passive funds (that basically spread the pooled investments across the index) makes a lot of sense. Investing in mutual funds that track the index used to be the best way to perform this task, but several years ago, ETFs were born, and offer a cheaper way (i.e. lower management fees) to invest in an index. How exactly do they do this?

When you buy a mutual fund, the mutual fund manager issues you shares of the mutual fund and takes your cash investment. But now he has to keep the cash around, which drags the whole fund’s return, or he has to incur transaction costs buying shares of the underlying index. The same thing happens when you redeem your shares; the manager has to keep cash around to return your money (which drags on returns) or he has to incur transaction costs by selling stock to provide you with cash.

The first ETF was a financial product innovation that started in Canada and has now spread through the world like wild fire due to its advantages. ETFs don’t have to incur transaction costs or keep pools of cash around for when individuals buy and sell shares, because these shares are issued in large blocks and are traded in the secondary market (meaning when you buy/sell a share, you’re buying/selling an existing share, which doesn’t require the issuing/redemption of a new one).

Shares in large blocks can be issued or redeemed from time to time as needed, but most of the time they are in the hands of dealers who make money off the bid/ask spread of the ETF (like a regular stock). The dealers compete with each other for volume, however, so the bid/ask spreads are kept competitive for liquid ETFs (just like regular stocks). Unlike closed-end funds, however, which can trade at huge discounts or premiums to their underlying assets as we saw here, ETF shares can indeed be redeemed if there are arbitrage opportunities. For example, if the ETF trades at a discount to the underlying assets, traders can buy the ETF and redeem it for a profit, which results in ETFs trading fairly close to their Net Asset Values.

If you’re an index investor who owns mutual funds, consider checking if an ETF exists that invests in the same index…you will likely increase your returns by almost 1% per year due to the management fee cost savings.