An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks. An exchange-traded fund holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most exchange-traded funds track an index, such as the S&P 500 or MSCI EAFE. exchange-traded funds may be attractive as investments because of their low costs, tax efficiency, and stock-like features.
Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an exchange-traded fund directly from/to the fund manager, and then only in creation units, large blocks of tens of thousands of exchange-traded fund shares, which are usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the exchange-traded fund shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the exchange-traded fund shares and help ensure that their intraday market price approximates the net asset value of the underlying assets. Other investors, such as individuals using a retail brokerage, trade exchange-traded fund shares on this secondary market.
An exchange-traded fund combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. exchange-traded funds have been available in the US since 1993 and in Europe since 1999. exchange-traded funds traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed exchange-traded funds.
Structure
Exchange-traded funds offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an exchange-traded fund can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, exchange-traded funds do not sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions purchase and redeem exchange-traded fund shares directly from the exchange-traded fund, but only in large blocks, varying in size by exchange-traded fund from 25,000 to 200,000 shares, called "creation units." Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the exchange-traded fund, although some exchange-traded funds may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.
The ability to purchase and redeem creation units gives exchange-traded funds an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of exchange-traded fund shares. Existing exchange-traded funds have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals. If there is strong investor demand for an exchange-traded fund, its share price will (temporarily) rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the exchange-traded fund and sell the component exchange-traded fund shares in the open market. The additional supply of exchange-traded fund shares increases the ETF's market capitalization and reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an exchange-traded fund and its shares trade at a discount from net asset value.
In the United States, most exchange-traded funds are structured as open-end management investment companies (the same structure used by mutual funds and money market funds), although a few exchange-traded funds, including some of the largest ones, are structured as unit investment trusts. exchange-traded funds structured as open-end funds have greater flexibility in constructing a portfolio and are not prohibited from participating in securities lending programs or from using futures and options in achieving their investment objectives. Under existing regulations, a new exchange-traded fund must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the exchange-traded fund structure. In 2008, however, the SEC proposed rules that would allow the creation of exchange-traded funds without the need for exemptive orders. Under the SEC proposal, an exchange-traded fund would be defined as a registered open-end management investment company that:
- Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated on a per share basis by a national securities exchange at regular intervals during the trading day;
- Identifies itself as an exchange-traded fund in any sales literature;
- Issues shares that are approved for listing and trading on a securities exchange;
- Discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and
- Either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund.
The SEC rule proposal would allow exchange-traded funds either to be index funds or to be fully transparent actively managed funds. Historically, all exchange-traded funds in the United States have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed exchange-traded funds. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust, and the first actively managed exchange-traded fund in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on 25 March 2008. The SEC rule proposal indicates that the SEC is not suggesting that it will not consider future applications for exemptive orders for actively managed exchange-traded funds that do not satisfy the proposed rule's transparency requirements.
Some exchange-traded funds invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity exchange-traded funds are similar in practice to exchange-traded funds that invest in securities, they are not "investment companies" under the Investment Company Act of 1940.
Publicly traded grantor trusts, such as Merrill Lynch's HOLDRS securities, are sometimes considered to be exchange-traded funds, although they lack many of the characteristics of other exchange-traded funds. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not "investment companies" under the Investment Company Act of 1940.
History
exchange-traded funds had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.
A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.
Nathan Most, an executive with the exchange, developed Standard & Poor's Depositary Receipts (NYSE: SPY), which were introduced in January 1993. Known as SPDRs or "Spiders," the fund became the largest exchange-traded fund in the world. In May 1995 they introduced the MidCap SPDRs (NYSE: MDY).
Barclays Global Investors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indexes, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.
In 1998, State Street Global Advisors introduced the "Sector Spiders", which follow the nine sectors of the S&P 500. Also in 1998, the "Dow Diamonds" (NYSE: DIA) were introduced, tracking the notable Dow Jones Industrials Average. In 1999, the influential "cubes" (NASDAQ: QQQQ) were launched attempting to replicate the movement of the NASDAQ 100.
Since then exchange-traded funds have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of May 2008, there were 680 exchange-traded funds in the U.S., with $610 billion in assets, an increase of $125 billion over the previous twelve months.
Investment uses
Exchange-traded funds generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because exchange-traded funds can be economically acquired, held, and disposed of, some investors invest in exchange-traded fund shares as a long-term investment for asset allocation purposes, while other investors trade exchange-traded fund shares frequently to implement market timing investment strategies. Among the advantages of exchange-traded funds are the following:
- Lower costs - exchange-traded funds generally have lower costs than other investment products because most exchange-traded funds are not actively managed and because exchange-traded funds are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. exchange-traded funds typically have lower marketing, distribution and accounting expenses, and most exchange-traded funds do not have 12b-1 fees.
- Buying and selling flexibility - exchange-traded funds can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.
- Tax efficiency - exchange-traded funds generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.
- Market exposure and diversification - exchange-traded funds provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index exchange-traded fund inherently provides diversification across an entire index. exchange-traded funds offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.
- Transparency - exchange-traded funds, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.
Some of these advantages derive from the status of most exchange-traded funds as index funds.
Types of exchange-traded funds
Index exchange-traded funds
Most exchange-traded funds are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index. Some index exchange-traded funds, known as leveraged exchange-traded funds or inverse exchange-traded funds, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index. As of February 2008, index exchange-traded funds in the United States included 415 domestic equity exchange-traded funds, with assets of $350 billion; 160 global/international equity exchange-traded funds, with assets of $169 billion; and 53 bond exchange-traded funds, with assets of $40 billion.
Some index exchange-traded funds invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication." Other index exchange-traded funds use "representative sampling," investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the exchange-traded fund to achieve its investment objective. For index exchange-traded funds that invest in indexes with thousands of underlying securities, some index exchange-traded funds employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.
Commodity exchange-traded funds or ETCs (Exchange Traded Commodities)
Commodity exchange-traded funds invest in commodities, such as precious metals and futures. Among the first commodity exchange-traded funds were gold exchange-traded funds, which have been offered in a number of countries. The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003. Commodity exchange-traded funds generally are index funds, but track non-securities indexes. Because they do not invest in securities, commodity exchange-traded funds are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.
Exchange Traded Commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to Exchange Traded Funds (exchange-traded funds) and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on-Exchange, during market hours.
ETCs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity exchange-traded fund that might not be immediately apparent; for example, buyers of an oil exchange-traded fund such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the non-professional investor is the method that these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.
Bond exchange-traded funds
Exchange-traded funds that invest in U.S. Government bonds—like the iShares Barclays 20+ Year Treasury Bond Fund, NYSE: TLT, are known as Bond exchange-traded funds. They thrive during economic recessions because investors pull their money out of the stock market and into U.S. Treasuries. Because of this cause and effect relationship, the performance of Bond exchange-traded funds may be indicative of broader economic conditions. There are several advantages to Bond exchange-traded funds such as the reasonable trading commissions they generate, but this benefit can be negatively offset by trading fees if bought and sold through a third party.
Currency exchange-traded funds
In 2005, Rydex Investments launched the first ever currency exchange-traded fund called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index exchange-traded fund in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market exchange-traded fund (LSE: XGBP) and US Dollar Money Market exchange-traded fund (LSE: XUSD) in London.
Actively managed exchange-traded funds
Actively managed exchange-traded funds are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. The actively managed exchange-traded funds approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it is willing to consider allowing actively managed exchange-traded funds that are not fully transparent in the future.
The fully transparent nature of existing exchange-traded funds means that an actively managed exchange-traded fund is at risk from arbitrage activities by market participants who might choose to front-run its trades. The initial actively traded equity exchange-traded funds have addressed this problem by trading only weekly or monthly. Actively traded debt exchange-traded funds, which are less susceptible to front-running, trade their holdings more frequently.
The initial actively managed exchange-traded funds have received a lukewarm response and have been far less successful at gathering assets than were other novel exchange-traded funds. Among the reasons suggested for the initial lack of market interest are the steps required to avoid front-running, the time needed to build performance records, and the failure of actively managed exchange-traded funds to give investors new ways to make hard-to-place bets.
Exchange-traded grantor trusts
An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRS, a proprietary Merrill Lynch product. HOLDRS are neither index funds nor actively-managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRS have some qualities in common with exchange-traded funds, including low costs, low turnover, and tax efficiency, many observers consider HOLDRS to be a separate product from exchange-traded funds.
Hedge Fund exchange-traded funds
Hedge fund exchange-traded funds are a new type of an exchange-traded fund. A hedge fund exchange-traded fund tracks a hedge fund and follow a group of hedge fund's activity. These new Hedge Fund ETF's are offered by IndexIQ they include IQ Hedge Multi-Strategy Composite, IQ Hedge Global Macro, IQ Hedge Long/Short Equity, IQ Hedge Event-Driven and IQ Hedge Market Neutral
Each of these hedge fund ETF's follows a general hedge fund strategy (Event-Driven, Market Neutral etc...).
Leveraged exchange-traded funds
A leveraged exchange-traded fund, or simply leveraged exchange-traded fund, is a special type of exchange-traded fund that attempts to achieve returns that are more sensitive to market movements than a non-leveraged exchange-traded fund. Leveraged index exchange-traded funds are often marketed as bull or bear funds. A bull exchange-traded fund fund might for example attempt to achieve daily returns that are 2.0 times more pronounced than the Dow Jones Industrial Average or the S & P 500. A bear fund on the other hand may attempt to achieve returns that are -2.0 times the daily index return, meaning that it will gain twice the loss of the market. Leveraged exchange-traded funds require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return. The most common way to construct leveraged exchange-traded funds is by trading future contracts.
The rebalancing of leveraged exchange-traded funds may have considerable costs when markets are volatile. The problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year(0.9982^252=0.63). Investors may however circumvent this problem by buying futures directly, accepting a varying leverage ratio.
Exchange-traded funds compared to mutual funds
Costs
Because exchange-traded funds trade on an exchange, each transaction is subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. For example, a typical flat fee schedule from an online brokerage firm in the United States range from $10 to $20, but can be as low as $3 with discount brokers. Due to this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed immediately, while for someone making a $200,000 investment, the commission cost may be negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Thus when low or no-cost transactions are available, exchange-traded funds become very competitive.
Most exchange-traded funds have a lower expense ratio than comparable mutual funds. Not only does an exchange-traded fund have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an exchange-traded fund does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. Mutual funds can charge 1% to 3%, or more; index fund expense ratios are generally lower, while exchange-traded funds are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference. The cost difference is more evident when compared with mutual funds that charge a front-end or back-end load as exchange-traded funds do not have loads at all. The redemption fee and short-term trading fees are examples of other fees associated with mutual funds that do not exist with exchange-traded funds. Traders should be cautious if they plan to trade inverse and leveraged exchange-traded funds for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.
Investors should be reminded that the lower direct cost of ownership of exchange-traded funds does not necessarily result in higher rates of return when compared with a similar index mutual fund.
Taxation
Exchange-traded funds are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, exchange-traded funds are not redeemed by holders (instead, holders simply sell their exchange-traded fund shares on the stock market, as they would a stock, or effect a non-taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the exchange-traded fund trades to reflect changes in the underlying index. In most cases, exchange-traded funds are more tax-efficient than conventional mutual funds in the same asset classes or categories.
In the U.K., exchange-traded funds can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares.
Trading
Perhaps the most important benefit of an exchange-traded fund is the stock-like features offered. Since exchange-traded funds trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many exchange-traded funds have the capability for options (puts and calls) to be written against them. Covered call strategies allow investors and traders to potentially increase their returns on their exchange-traded fund purchases by collecting premiums (the proceeds of a call sale or write) on calls written against them. Mutual funds do not offer those features.
For example, an investor in a mutual fund can only purchase or sell at the end of the day at the mutual fund's closing price. This makes stop-loss orders much less useful for mutual funds, and not all brokers even allow them. An exchange-traded fund is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the exchange-traded fund for cash throughout regular trading hours, and often after-hours on ECNs. Exchange-traded fund liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid exchange-traded funds such as SPDRs can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.
Another advantage is that exchange-traded funds, like closed-end funds, are immune from the market timing problems that have plagued open-end mutual funds. In these timing attacks, investors trade in and out of a mutual fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term shareholders. With an exchange-traded fund (or closed-end fund) such an operation is not possible—the underlying assets of the fund are not affected by its trading on the market.
Investors can profit from the difference in the share values of the underlying assets of the exchange-traded fund and the trading price of the ETF's shares. exchange-traded fund shares will trade at a premium to net asset value when demand is high and at a discount to net asset value when demand is low. In effect, the exchange-traded fund is providing a system for arbitraging value in the market. As the initial costs are one-off, the exchange-traded fund vehicle offers some cost advantages over other forms of pooled investment vehicles.
Criticism
John C. Bogle, founder of The Vanguard Group, a leading issuer of index mutual funds (and, since Bogle's retirement, of exchange-traded funds), has argued that exchange-traded funds represent short-term speculation, that their trading expenses decrease returns to investors, and that most exchange-traded funds provide insufficient diversification. He concedes that a broadly diversified exchange-traded fund that is held over time can be a good investment.
Exchange-traded funds are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of exchange-traded funds that track domestic indexes is generally less than 2%, the deviations may be more significant for exchange-traded funds that track certain foreign indexes. The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded exchange-traded funds not infrequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche exchange-traded funds, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.
The tax advantages of exchange-traded funds are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place). However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.
In a survey of investment professionals, the most frequently-cited disadvantage of exchange-traded funds was the unknown, untested indexes used by many exchange-traded funds, followed by the overwhelming number of choices.
Some critics claim that exchange-traded funds can be, and have been, used to manipulate market prices, including having been used for short selling that has been asserted by some observers (including Jim Cramer of theStreet.com) to have contributed to the market collapse of 2008. |
