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Exchange traded funds (ETFs)

Comparing ETF's, open-end, and closed-end funds. Created by Sal Khan.

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Video transcript

So far, we looked at open-end mutual funds that can kind of grow and shrink depending on how many investors want to invest in that fund. They can grow by creating new shares and selling those shares to the general public. And they can shrink because someone who wants their money back goes to the fund and says, you have to buy this back from me at the end NAV, at the net asset value, per share. But the problem with it, actually there's a couple problems, is that the manager here has to always keep a little cash set aside in case some of the investors come to him and say, hey, I want you to buy my share back. I want liquidity. And the other thing that they have to worry about, at least from the investor's point of view, is they can only buy or sell at the end of the day. And that will only happen at the net asset value per share. And on top of that, the fund manager, or whoever's running the fund, has to worry about actually transacting between all of these different investors. Now, on the other side of things, we looked at the closed-end fund. The closed-end fund couldn't kind of dynamically grow and shrink by creating new shares, or by buying them back. But what was good about them is, is that they were freely trading on exchanges, maybe on the NASDAQ or the New York Stock Exchange. And because there was none of this kind of back and forth between the fund managers, or whoever was kind of doing the operations of the fund and the investors, they didn't have to put cash aside. And they didn't have to have all of this kind of overhead in dealing with the investors. Now, you're probably saying, well isn't there a way? Or maybe there's a way to get the best of both worlds? A fund that could grow dynamically, that could create new shares when there was demand from investors. But at the same time, those new shares could be traded on an open market. And that combination, or you can kind of view it as a combination of the two, actually exists, and they're called exchange traded funds, or ETFs for short. And you might say, hey, wait. Isn't a closed-end fund exchange traded? And it is. These actually do trade hands on the stock exchanges. But these are officially ETFs. When someone tells you an ETF, the way to think about it, it's a combination of both. But what it does is it limits of the interaction. So when you have just a regular, open-end mutual fund any individual investor can come to the fund say, here is my share. Buy it back from me. Eliminate that share. And that creates a lot of overhead here. On an exchange traded fund only approved people, and these are usually large institutions, can go to the fund and say, I want to buy or redeem a big block of shares. So an exchange traded fund, instead of creating one share of time, it might create 5,000, or 10,000, or 100,000 shares at a time. And on the other side of things, if someone wanted to redeem their shares, they would redeem 5,000, 10,000, or 100,000 shares at the same time. And what's good there from the funds point of view, is that they don't have to deal with all of these small transactions. They can do big transactions with big entities. So that saves them cost on overhead. And since these big people go and kind of by these big blocks of shares, they can then go and sell them in the open market, or they could trade them in the open market. So if want to buy in to an ETF, instead of buying it directly from the ETF you would buy it from one of these big institutions that buy big blocks of shares. So they're now buying a big block of-- maybe this is 10,000 shares right over here. And then they will trade in the open market. So you kind of get the best of both worlds and. In general, ETFs also have lower fees. And they have lower fees one, because they don't have to do all of this back and forth between each individual investor. And most ETFs are not actively managed. And when I say actively managed I'm talking about the situation where you had Pete. And Pete says that he's just an awesome stock picker. He can beat the market. He can do all of-- you know he really researches companies. And he thinks that there's some value that he creates by doing that. When something is not actively managed, and exchange traded funds tend to not be, they're saying, look, we're just going to buy the market. Or we're just going to buy some commodity. So when you go into an exchange traded fund, you're really just trying to buy some asset class, maybe it's the S&P 500. Maybe it's some type of exchange traded funds that buys gold as assets. Or maybe it's buying some other type of commodity. And so because it's not actively managed, the argument would be, that they don't need as much in management fees. So they will have lower fees. So it's a combination, they can grow arbitrarily large, and some of the largest exchange traded funds are super huge. They have much lower fees. And they have this tradability. You can trade them at any kind of second on the market. You don't have to wait until the end of the day like an open-end fund.