# Understanding ETFs and Why They Beat Mutual Funds

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This chapter is from the book

## How Does an Index Work?

To understand how an index works, consider the Three Paths Green Index depicted in Table 1.1, which lists the securities and their weights in the index.3

#### Table 1.1. Components and Weights of the Three Paths Green Index

 Security Weight Sunny Solar 50% Windy Windmills 25% Clean Cars 25% Total 100%

The stocks in the Three Paths Green Index determine the performance of the index in proportion to their weighting. For example, while Sunny Solar makes up only one-third (33.33%) of the total membership of the index, its 50% weighting makes its contribution to the index's performance equal to that of both Windy Windmills and Clean Cars combined.

The Three Paths Green Index is used to create the Three Paths Green ETF. Despite owning a fund underlain by those three stocks, the average investor cannot redeem the ETF for individual shares of Sunny Solar, Windy Windmills, or Clean Cars. Only market makers who buy and sell large amounts of securities can create an ETF by depositing the component securities, or redeem an ETF to receive the individual securities that make up the ETF.4 The average investor will buy or sell the ETF and not exchange it for the individual shares. Still, the shares that make up the ETF will actually determine the price of the ETF.

Consider how the prices of the components affect the value of the Three Paths Green Index. The index's value is determined by multiplying the price of each stock by the weight of each stock in the index and totaling up the value. The fund's value is determined by multiplying the fund's index value by \$1.00. Let's see what happens to the index, and the ETF, when the prices change in the shares of the three companies.5 The weights indicate how much the movement of a stock's price will affect the index and consequently the ETF.6

Table 1.2 shows how price changes affect the value of the index and the ETF. The index value changes depending on the price action in each of the securities. On Day 1, each stock in the index has a price of \$100, the index has a value of 100, and the fund trades at \$100. The value of the index is determined by taking the price of each stock, multiplying it by the respective weighting to determine an index value. The index values for the three stocks are added to obtain an index value of 100 and fund value of \$100. On Day 2, Sunny Solar increases in price 50% to \$150, while the other two components stay the same. This leads to a 25% increase in the value of the index to 125, and the fund rises to \$125. On Day 3, the price of Sunny Solar falls to \$100, but the other two components each rise \$50. The index remains unmoved from Day 2 staying at 125, and the fund is at \$125. On Day 4, the price of Sunny Solar falls to \$50, while the other components return to \$100, and the index falls to 75 and the fund to \$75. On Day 5, Sunny Solar returns to \$100, yet the other two components both fall to 50, and the index remains at 75 and the fund at \$75. Figure 1.1 shows the effect on the price of the ETF. The impact of each price move is in proportion to its weight in the index. The same applies to larger indices and funds with many components, although there might be some premiums, or discounts, in the value of the fund relative to the index due to a number of factors discussed later in this chapter in the section "Index Risk."

#### Table 1.2. Index Values and Weighting of the Three Paths Green Index (Index Value = Price x Weight)

 Day 1 Day 1 Day 2 Day 2 Day 3 Day 3 Day 4 Day 4 Day 5 Day 5 Security Weight Price Index Value Price Index Value Price Index Value Price Index Value Price Index Value Sunny Solar 50% \$100 50 \$150 75 \$100 50 \$50 25 \$100 50 Windy Windmills 25% \$100 25 \$100 25 \$150 37.5 \$100 25 \$50 12.5 Clean Cars 25% \$100 25 \$100 25 \$150 37.5 \$100 25 \$50 12.5 Index value 100 125 125 75 75 ETF price \$100 \$125 \$125 \$75 \$75