An ETF is a simple way that an investor can own a fractional share of an index. As an example, the S&P 500 ETF SPY cost $291.12 at the close on August 8th of 2019. So an investor that has roughly $300 to invest, can buy one share of the S&P 500 spider and have a diversified portfolio of stocks. That ETF moves nearly perfectly with the underlying S&P 500 index. So by buying that particular ETF, one is in essence investing in the S&P 500 it's self. How then does an ETF actually work? We start out with a company that's known as an authorized participant. Authorized participants are a set of companies who are authorized to create ETFs and are primarily the large banks and investment companies that many of us have heard of, such as JPMorgan Chase or Bank of America. So let's suppose that our authorized participant has decided that they want to create a particular ETF. They will take either shares that they happen to own or cash in order to buy a set of shares and place those shares or cash in a trust. That trust is then going to invest the cash or hold the shares in a proportion that represents the S&P 500 Index. It's going to give back to our authorized participant what is called a creation unit. A creation unit is something like a 100,000 shares of an ETF. So again, just as an example, our authorized participant gives $20 million to a trust, our creation unit basically splits that $20 million into a 100,000 equal shares. The authorized participant then can go ahead and hold on to those ETF shares if they want to invest in the ETF for some particular reason, or they can sell those shares on an exchange. So one of the nice things about an ETF is that it trades on an exchange just like any other stock. So just in the same way that you could buy, say for example, a share of Apple stock, you could buy a share of the SPY ETF. How does this work? Well, let's think about a very simple example of creating an ETF. Again, we're going to use the very simple index that we discussed before of Apple and Microsoft. We have some authorized participants. So for example, Bank of America. They'll buy shares of Apple and Microsoft and put them in a trust. To put some numbers behind this particular concept, I have constructed an ETF that replicates market weights for Apple and Microsoft. So an example that we could have here, would be a situation in which Bank of America goes out and buys on the market 2.1 million shares of Apple and 3.396 million shares of Microsoft. At the prices that we discussed before, that holding of Apple would be worth about $331 million and the holding of Microsoft would be worth about $345 million. The total value of the portfolio, the cost to buy all of those shares, would be the sum of those two numbers or about $676 million. If we look at the actual weights of Apple and Microsoft in those portfolios, taking 33,1254 and dividing it through 676,286,068, we'll get a weight of 0.489013 or about 49 percent. That matches Apple's actual market weight in a portfolio of Apple and Microsoft to the sixth decimal place. Similarly, Microsoft's weight will be $345 million divided by $676 million or about 0.510187, which again matches Microsoft value weight in an index of these two stocks. Bank of America has created this ETF essentially by buying shares of the underlying stock, Apple and Microsoft. The trust that they put their shares into is then going to create 10 million shares of an ETF, which are going to be exchanges for the actual shares. The total value of the ETF was about $676 million. So each of those 10 million shares is going to sell for $67.63 on an exchange. That share value of $67.63 should represent any possible changes to the value of the underlying stocks as we'll illustrate in just a moment. So continuing our simple example, let's suppose that Microsoft's price rose from a $101.57 at the end of 2018 to a $110. Here's what's going to happen to the value-weighted index. So again, we have a bit in excess of 7.6 billion shares of Microsoft outstanding and 4.7 billion shares of Apple outstanding. Microsoft's price has risen to a $110 and Apple's prices remained unchanged at a $157.74. Microsoft's new market capitalization is going to be the product of the 7.6 billion shares outstanding and the new price of a $110 or about $844 million. Apple's market cap is not going have changed as we have the same number of shares outstanding about 4.7 billion and the same price, a $157.74 to make the market cap remain at about $748 billion. Adding these two up, we have a new total market capitalization of about $1.592 trillion. Out of that, 844 million divided by 1.592 trillion, or 53 percent of the market capitalization is now in Microsoft, and $748 billion divided by $1.592 trillion, or about 47 percent is now the market capitalization, weight for Apple. If we look at the total return of this particular index, we'll see that market capitalization has gone from 1.528 trillion to $1.592 trillion. Calculating the return by looking at the gain on the market capitalization divided through by the original market capitalization, we'll see that the return on this particular index would be 4.23 percent. So how does that get reflected in the ETF? Considering Apple, the number of shares that we have in the ETF has not changed, it's still 2.1 million. Its price hasn't changed, so its value is still 331 million. Microsoft shares also have not changed, so we have about 3.4 million shares of Microsoft, but its value changes because its price has gone up to $110. So its value is now about $373 million. The total value of the index or the ETF is now 331 million plus 373 million, or about 704 million. If we will look at Apple's new weight in this index, taking a value of 331 million and dividing through by 704 million, we wind up with a weight of 47 percent. Microsoft's new value of 373 million divided through by the new total of 704 million, has now a weight of 33 percent. As you can see, the weights that we have in the ETF are also the weights that we see in the index itself. Apple has a weight of 47 percent, and Microsoft of 53 percent. So it should come as no surprise given that we have 10 million shares, that those 10 million shares that are now worth $70.49 are going to earn a return of the new value of $70.49 minus the original value of $67.63, divided by the original value of $67.63, to provide us a return of 4.23 percent, which is exactly what we see on the underlying index. This is how an ETF replicates the performance of an underlying index, but by selling fractional shares of the particular index allows individual investors to own a small fraction of the index. The main advantage to ETFs other than their ease of use and the fact that they're able to be purchased without having to purchase an entire index, is their low fees. Here I have assembled the table of a number of different asset class ETFs that are similar to the ones that are used by Wealthfront in their investing, and they range from US stocks to emerging market bonds, and so they spend most of the different asset classes that Wealthfront discusses in their materials. The lowest cost index is that of US stocks, the Vanguard Total Market Index or VTI, which has a fee as a percent of net asset value of only 0.03 percent. So as opposed to actively managed funds, which we mentioned can have fees of 0.75 percent to one percent, VTI represents a very low cost way of getting invested in the US stock market. Fees for these different asset classes generally depend on liquidity and ease of access of the underlying markets. So you can see that the fee charged for the FTSE Developed Market Index, VEA, is not that different from the fee charged for VTI, the Vanguard Total Market Index at 0.05 percent. Again, that's because developed markets are relatively liquid, and it's relatively easy to purchase equities in developed markets. On the other hand, stocks in emerging markets tend to be much more difficult to acquire, and the markets tend to be much less liquid. So as a result, you can see that the fee in the FTSE Emerging Market Index, VWO, is somewhat higher at 0.12 percent. The highest fee that's charged amongst these asset classes is for emerging market bonds. The Emerging Market Government Bond Index or VWOB, has a fee of about 0.3 percent. Again, this fee is much higher than that for US stocks, but reflects the fact that is much more difficult to get access to emerging market bonds than it is to US stocks, and is still considerably lower than that of actively managed mutual funds. To conclude, ETFs or exchange traded funds are a mechanism for getting exposure to asset classes through an index at a low cost. Robo-advisors typically use ETFs to assist in low-fee asset management. Again, as we discussed in previous slides, typical asset in managers may charge one to two percent for their asset management fees, which can rob an investor of 25 to 50 percent of the ultimate value of their portfolio. By using low-fee ETFs, robo-advisors allow investors to keep most of their money in their own wealth. In our next set of videos, we'll ask to ourselves, if we can invest in ETFs ourselves, what exactly is the value proposition or the value added for a robo-advisor? That is, we have discussed so far the fact that robo-advisors mostly follow typical finance class advice, invest in ETFs which typical investors can invest in, and the question outstanding is, what are we getting when we invest our money with a robo-advisor?
