Exchange-Traded Funds (Etfs) : Ken Hawkins
Exchange-Traded Funds (Etfs) : Ken Hawkins
Exchange-Traded Funds (Etfs) : Ken Hawkins
Funds (ETFs)
by Ken Hawkins
http://www.investopedia.com/university/exchange-traded-fund/
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Table of Contents
Introduction
(Page 1 of 21)
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style. Because ETFs are designed to track an index, they are considered
passively managed; most mutual funds are considered actively managed. (For
more insight, read Mutual Fund Or ETF: Which Is Right For You? and Active Vs.
Passive Investing In ETFs.)
Although index mutual funds are available to cover most of the major indexes,
ETFs cover a broader range of indexes, providing more investing options to the
ETF investor than the index mutual fund investor. (For more insight, read ETFs
Vs. Index Funds: Quantifying The Differences.)
This tutorial provides a basic understanding of what an ETF is and how it might
be used by an investor.
Background
Compared to mutual funds, ETFs are relatively new. The first U.S. ETFs were
created by State Street Global Advisors with the launch of the S&P 500
depositary receipts, also know as SPDRs ("spiders"). Although the first ETFs
tended to track broad market indexes, more recent ETFs have been developed
to track sectors, fixed income, global investments, commodities and currencies.
According to Morgan Stanley, by the end of 2007, there were 1,171 ETFs trading
worldwide, with assets approaching $800 billion.
ETFs represent shares of ownership of a unit investment trust (UIT), which holds
portfolios of stocks, bonds, currencies or commodities. ETFs are often compared
the mutual funds:
A mutual fund investor purchases or redeems directly from the fund, at the
mutual fund's net asset value (NAV), which is calculated at the end of
each trading day. An investor who buys an ETF purchases the shares on
The creation and redemption process for ETF shares is almost the exact
opposite to that of mutual fund shares. When investing in mutual funds,
investors send cash to the fund company, which then uses that cash to
purchase securities and issue additional shares of the fund. When
investors want to redeem their mutual fund shares, the shares are
returned to the mutual fund company in exchange for cash. The creation
of an ETF, however, does not involve cash. (For insight, see An Inside
Look At ETF Construction.)
Creation
ETFs are security certificates that state the legal right of ownership over a portion
of a basket of individual stock certificates. Creating an ETF in the U.S. first
requires a fund manager to submit a detailed plan to the Securities and
Exchange Commission (SEC). The plan describes a set of procedures and the
composition of the ETF.
Typically, only the largest money management firms, with experience in indexing,
can create and manage ETFs. These firms are in touch with major investors,
pension funds and money managers throughout the world, which have the pool
of stocks required for ETF creation. The firms also create demand by lining up
customers, either institutional or retail, to buy a newly introduced ETF.
Redemption
To redeem the shares, an authorized participant buys a large block of ETFs,
forwards them to the custodial bank and receives an equivalent basket of
individual stocks. These stocks can then be sold on a stock exchange although
they are usually returned to the institution that loaned the shares.
Redeem the ETF, by submitting the shares to the ETF fund in exchange
for the underlying shares
In practice, the individual investors will do the latter. Because of the limitations
placed on the redemption of the ETFs shares, they can not be called mutual
funds.
Arbitrage
A important characteristic of an ETF is the opportunity for arbitrage. When the
ETF price starts to deviate from the underlying net asset value (NAV) of the
component stocks, participants can step in and take profit on the differences. If
the ETF shares are trading at a discount to underlying securities (a price lower
than the NAV), then arbitrageurs buy ETF shares on the open market. The
arbitrageurs will then form creation units, redeem the creation units to the
custodial bank, receive the underlying securities, and sell them for a profit. If the
ETF shares are trading at a premium to the underlying securities (a price higher
than the NAV), arbitrageurs will buy the underlying securities on the open market,
redeem them for creation units, and then sell the ETF shares for a profit.
The actions of the arbitrageurs result in ETF prices that are kept very close to the
NAV of the underlying securities. (For more insight, read Arbitrage Squeezes
Profit From Market Inefficiency.)
SPDRs
Standard & Poor's Depositary Receipts (SPDRs) are managed by State Street
Global Advisors (SSgA). The most popular SPDR is the SPDR S&P 500 EDF
(SPY), but State Street Global Advisors also has a series of ETFs that track the
major S&P 500 sectors. They are called Select Sector SPDRs.
iShares
The iShares family of ETFs is branded and managed by Barclays Global
Investors. According to Morgan Stanley, Barclays is the largest providers of ETFs
in the world, providing a diverse offering of ETFs covering broad-based U.S.,
international, industry sectors, fixed income and commodities.
VIPERs
VIPERS ETFs are issued by Vanguard, better known for its diverse selection of
index mutual funds. Vanguard Index Participation Receipts (VIPERs) offer a
number of different ETFs, ranging form broad-based to industry sector as well as
international and bond ETFs. (To learn more read, What is the difference
between iShares, VIPERS and spiders?)
PowerShares
Features
The vast majority of ETFs are designed to track an index, so their performance is
close to that of an index mutual fund, but they are not exact duplicates. A
tracking error, or the difference between the returns of a fund and the returns of
the index, can arise due to differences in composition, management fees,
expenses, and handling of dividends. Let's take a look at some of these factors.
Buying and Selling ETFs Can Be Good for the Small Investor
ETFs enjoy continuous pricing; they can be bought and sold on a stock exchange
throughout the trading day. Because ETFs trade like stocks, you can place
orders just like with individual stocks - such as limit orders, good-until-canceled
orders, stop loss orders etc. They can also be sold short. Traditional mutual
funds are bought and redeemed based on their net asset values (NAV) at the
end of the day. ETFs are bought and sold at the market prices on the exchanges,
which resemble the underlying NAV but are independent of it. However,
arbitrageurs will ensure that ETF prices are kept very close to the NAV of the
underlying securities.
Although an investor can buy as few as one share of an ETF, most buy in board
lots. Anything bought in less than a board lot will increase the cost to the
investor. Anyone can buy any ETF no matter where in the world it trades. This
provides a benefit over mutual funds, which generally can only be bought in the
country in which they are registered.
Treatment of Dividends
An ETF typically pays out dividends received from the underlying stocks on a
quarterly basis. However, the underlying stocks pay dividends throughout the
quarter. Therefore, these funds can hold cash for various time periods throughout
the quarter, even though the underlying benchmark index is not composed of
cash. With dividend-paying ETFs, the cash ends up in your brokerage account
instead, just like the dividend on a regular stock. If you want to reinvest that cash,
you have to make another purchase.
Tax Efficiency
Because index ETFs are passively managed portfolios, they tend to offer greater
tax benefits than regular mutual funds. They generate fewer capital gains due to
low turnover of the securities, and realize fewer capital gains than actively
managed funds. An index ETFs only sells securities to reflect changes in its
underlying index. Traditional mutual funds accumulate these unrealized capital
gains liabilities as the portfolio's stocks increase in value. When the fund sells
those stocks, it distributes the capital gains to its investors in proportion to their
ownership. This selling results in greater taxes for mutual fund owners. (For
related reading, see How To Use ETFs In Your Portfolio.)
Transparency
As mentioned, ETFs are designed to replicate the performance of their
underlying index or commodity. Investors always know exactly what they are
buying and can see exactly what constitutes the ETF. The fees are also clearly
laid out. Because mutual funds only have to report their holdings twice a year,
when you buy into a mutual fund, what you're getting may not be as clear.
Options
A number of ETFs have options that can be traded. They can be used to create
different investment strategies in conjunction with the underlying ETF. This
allows ETF investors to make use of leverage in their portfolios. (For more
insight, read Dissecting Leveraged ETF Returns.)
Index had 525 million shares outstanding, with total net assets of just over $73
billion. SPY trades on the American Stock Exchange (AMEX) and is one of the
most actively traded stocks, regularly trading more than 100 million shares per
day and sometimes over 400 million shares per day.
The SPY ETF tracks the performance of the S&P 500 index very closely; most of
the different between them is accounted for by SPY's expense ratio.
For many investors, the SPY represents a good core equity holding, in part
because of its low cost (expense ratio). For example, at a closing price of
$139.27 on May 21, 2008, 400 shares would have cost an investor $55,708.00
before commission. The expense ratio is .0945% which translates into an annual
cost to the investor of about $53, based on the current amount invested. (For
more on this, see 10 Reasons To Make ETFs The Core Of Your Portfolio.)
An investor could buy the SPY as a core portfolio holding to provide exposure to
the U.S. stock market. Alternatively, an investor could combine it with other ETFs
such as a small cap ETF, value-based ETF, or sector ETF to further customize
the exposure to U.S. stocks. An active trader could also use this ETF to actively
trade because it is exceptionally liquid, making it easy to buy and sell with little
cost.
Analyzing market trends, the economy and the company-specific factor, active
managers are constantly searching out information and gathering insights to help
them make their investment decisions. Many have their own complex security
selection and trading systems to implement their investment ideas, all with the
ultimate goal of outperforming the market. There are almost as many methods of
active management as there are active managers. These methods can include
fundamental analysis, technical analysis, quantitative analysis and
macroeconomic analysis.
Active managers believe that because the markets are inefficient, anomalies and
irregularities in the capital markets can be exploited by those with skill and
insight. Prices react to information slowly enough to allow skillful investors to
systematically outperform the market.
Passive investors believe in the efficient market hypothesis (EMH), which states
that market prices are always fair and quickly reflective of information. EMH
followers believe that consistently outperforming the market for the professional
and small investor alike is difficult. Therefore, passive managers do not try to
beat the market, but only to match its performance. (For background reading,
check out What Is Market Efficiency?)
Each side can make a strong logical case to support their arguments, although in
many cases, the support is due to different belief systems, much like opposing
political parties. However, each approach has advantages and disadvantages
that should be considered.
A disadvantage is that active investing is more costly, resulting in higher fees and
operating expenses. Having higher fees is a significant impediment to preventing
a manager from consistently outperforming over the long term. Active managers,
in an attempt to beat the market, tend to have a more concentrated portfolio with
fewer securities. However, when active managers are wrong, they may very
significantly under-perform the market. A manager's style could be out of favor
with the market for a period of time, which could result in lagging performance.
In much of the previous discussion comparing mutual funds to ETFs, the merits
of actively managed mutual funds are compared to the passively managed ETFs.
In some ways, it is like comparing apple to oranges. They have entirely different
characteristics. If a passive approach is desired, an investor should then consider
how best to implement it - by using index funds or exchange traded funds.
Costs
ETFs and index funds each offer advantages and disadvantages for managing
the costs of the underlying assets. In some cases, the difference in fees might
favor one over the other. Investors can buy no-load index funds without incurring
any transaction costs. Investors buying ETFs will have to pay brokerage
commissions.
Tax Efficiency
In nearly all cases, the structure of an ETF results in lower taxes versus the
equivalent index fund. This is because the way in which ETFs are created and
redeemed eliminates the need to sell securities. With index funds, securities are
bought and sold, although with lower turnover than a typical actively managed
fund. These transaction will trigger capital gains that have to be distributed to the
unit holders. (To learn more, read An Inside Look At ETF Construction.)
Dividends
The nature of ETFs requires them to accumulate dividends or interest received
from the underlying securities until it is distributed to shareholders at the end of
each quarter. Index funds invest their dividends or interest income immediately.
(For more insight, read Advantages Of Exchange-Traded Funds.)
Rebalancing
An investor with a portfolio of index funds or ETFs occasionally rebalances the
portfolio, selling some of the positions and purchasing others. A portfolio
containing ETFs incurs commissions by buying and selling the ETFs. Because
the investor typically trades in board lots, getting the exact weightings of each
ETF desired is practically impossible. This is especially true for small portfolios.
With index funds, an investor can achieve exact asset allocation weightings
because the investor can purchase fractional units. No-load funds have no
transaction costs. (For more on this topic, read Rebalance Your Portfolio To Stay
On Track.)
Dollar-Cost Averaging
The technique of using ETFs for dollar-cost averaging - spending a fixed dollar
amount at regular intervals on a portfolio - is generally impractical. The
commission costs and the extra cost involved in buying odd-lot shares makes
this strategy very expensive to implement. Mutual funds are a more suitable
investment vehicle for dollar-cost averaging.
Liquidity
A lack of liquidity on some ETFs, resulting in an increase in the bid-ask spread,
adds to the cost of trading ETFs. Also, the less popular ETFs are not likely to
have the same arbitrage interest of other ETFs, resulting in a potentially larger
difference between market prices and net asset value (NAV). Investors in index
funds can always get the NAV at the end of the day.
Equity ETFs
The first ETF was developed to create diversified portfolios based on equity
indexes. Because equities are a core asset class for investment portfolios, it is
important for investors to understand the different choices available to ensure
that the proper ETFs are deployed.
Use of a total market ETF, therefore, allows a long-term investor to cover U.S.
equities with a single ETF. Total and broad market ETFs tend to be inexpensive,
with low expense ratios and fairly narrow bid-ask spreads. Because they are so
broad, their volatility is generally less than that of a more focused equity ETF.
iShares MSCI ACWI (All Country World Index) Index Fund ETF
(Nasdaq:ACWI)
SPDR S&P World ex-US ETF (AMEX:GWL)
Sector ETFs
Sector ETFs allow investment in the stocks of different industrial sectors.
Investors can use the sector ETFs either as building blocks for a portfolio or to
make specific sector bets, like investing in energy or technology stocks. Building
a portfolio with sector ETFs, versus a broad based ETF, can provide for more
fine-tuning of a portfolio. Another advantage is rebalancing a portfolio on a
regular basis. The process of selling those sectors that have outperformed and
buying those that have underperformed - a sell high, buy low strategy - can
improve performance. Using sector ETFs will allow you to avoid or minimize
sectors that are over valued.
Examples of two families of sectors, which are based on the traditional market
capitalization indexes and their underlying sectors, are:
Leveraged ETFs
Leveraged ETFs can offer exposure to broad U.S. market indexes but with
greater volatility. So, if the S&P 500 rises by 1%, for example, the ProShares
Ultra S&P500 ETF (AMEX:SSO) will rise by 2%. Similarly, if the S&P 500 falls by
1%, the same ETF will drop by 2%. Unlike a regular ETF, which buys stocks in
the index, the leverage ETFs use options and futures. Because futures provide
more leverage than is necessary, the extra cash is used to purchase bonds,
which covers the expenses of the ETF, and to pay dividends to the owners of the
ETF. (To learn more, read Dissecting Leveraged ETF Returns and Rebound
Quickly With Leveraged ETFs.)
Quantitative ETFs
Quantitatively based ETFs use enhanced indexing to offer investors the
potential to outperform a benchmark index. The objective is to quantitatively
identify a subset of stocks from an index that are expected to outperform.
Quantitative indexing uses predefined rules to rank stocks based on a number of
different characteristics, which can include both fundamental and technical
factors. The top-ranked stocks out of the fund universe are selected to form an
index. The list includes a relatively small number of stocks that are rebalanced
quarterly, reflecting a change in rankings. A fundamentally-weighted index is a
type of quantitative indexing, using factors such as cash flow, revenue, and
earnings to weight the stocks rather than market cap. (For related reading, check
out Enhanced Index Funds - Shiny Paper Or Sparkling Gift?)
One issue with using a quantitative ETF is that you do not know the stocks it
holds, which can make building a properly diversified portfolio more difficult. Also,
the quarterly rebalancing results in a higher stock turnover, potentially higher
trading costs, and lower tax efficiency.
Although the first exchange-traded funds (ETFs) were developed for equities,
ETF providers have branched out into bond ETFs and asset allocation ETFs,
such as those that contain different asset classes.
In a stock ETF, the fund is generally composed of all the stocks in the index. This
is not the case in most bond ETFs. The fund holds a fraction of the bonds that
make up the underlying index. Bond prices are relatively straightforward - they
are a function of the risk-free rate, the coupon, the quality of the bond and the
years to maturity. Using those factors, the managers of a bond ETF use a
sampling technique that allows them to closely duplicate the performance of the
underlying bond index.
Bond ETFs pay out interest through a monthly dividend, while any capital gains
are paid out through an annual dividend. For tax purposes, these dividends are
treated as either interest income or capital gains.
While saving for retirement is the main reason investors buy target-date ETFs,
the funds are designed for any savings goal that has a targeted end date. They
were created for investors who do not want to manage their investments. An
investor can simply buy one ETF for the targeted retirement date and not have to
make any more decisions about that investment.
Although fixed income and equity investments are the core of a diversified
portfolio, the use of alternative asset classes can provide additional
diversification. These alternative investments can also be used for trading or
hedging existing positions. There are a number of different ETFs that allow
investors to establish positions in currencies or commodities. Also, with the use
of inverse ETFs, an investor can bet that the market will decline. (For related
reading, see Inverse ETFs Can Life A Falling Portfolio.)
Currency ETFs
Currency ETFs are designed to track the movement of a currency in the
exchange market. The underlying investments in a currency ETF will be either
foreign cash deposits or futures contracts. ETFs based on futures will invest the
excess cash in high-quality bonds, typically U.S. Treasury bonds. The
management fee is deducted from the interest earned on the bonds. (To learn
more, read Profit From Forex With Currency ETFs and Currency ETFs Simplify
Forex Trades.)
Commodity ETFs
Commodities are a separate asset class from stocks and bonds, so investing in
commodity ETFs can provide extra diversification in a portfolio. Because they are
hard assets, these ETFs can also provide protection against unexpected
inflation. (For more insight, read Commodities: The Portfolio Hedge.)
Commodity ETFs either hold the actual commodity or purchase futures contracts.
ETFs that use futures contracts have uninvested cash, which is used to purchase
interest-bearing government bonds. The interest on the bonds is used to cover
the expenses of the ETF and to pay dividends to the holders.
An inverse ETF can either use short positions of the underlying stocks or futures.
ETFs that use futures contracts can have the excess cash invested in bonds,
which covers the expenses of the ETF and can pay dividends to the owners.
There are a number of reasons to use inverse ETFs. For example, while
speculators can easily make a bearish bet on the market, for investors who have
positions that they do not want to sell because of unrealized capital gains or
illiquidity, this is not so easy. In this case, they can buy an inverse ETF as a
hedge.
In fact, many investors prefer to use inverse ETFs instead of selling short the
index. Inverse ETFs can be purchased in tax-deferred accounts, but shorting
stocks is not allowed because in theory, it exposes the investor to unlimited
losses. However, the most an investor in an inverse ETF can lose is the entire
value of the inverse ETF.
Core Holding
An investor can consider using a few ETFs as core portfolio holdings. A low-cost
diversified portfolio can easily be constructed with a few ETFs to cover the major
equity asset classes and the fixed-income market. From that starting point, the
investor can customize a portfolio with additional securities, mutual funds or other
ETFs. (To learn more, read 10 Reasons To Make ETFs The Core Of Your
Portfolio.)
Asset Allocation
With ETFs, building a portfolio for any asset allocation strategy is easy. It is even
possible to buy an ETF that is already diversified across different asset classes.
Diversification
ETFs allow the investor not only to diversify across all the major asset classes,
such as U.S. equity , foreign equity and fixed income, but also to diversify into
investments that have a low correlation to the major asset classes. This includes
areas like commodities, real estate, emerging markets, small cap stocks, and
others. (For more insight, read Introduction To Diversification.)
Hedging
The use of ETFs allows for a variety of hedging strategies. Investors who want to
hedge against a drop in the market can purchase inverse ETFs or leveraged
inverse ETFs, which rise when the market falls. An investor concerned about
inflation can hedge it by investing in commodities or inflation-protected bond
ETFs. Investors that have investments out side the U.S. can hedge their foreign
currency exposure with currency ETFs. Of course, investors can short an
appropriate ETF that can hedge against a very specific stock market exposure.
Many ETFs have options that can be used for other hedging strategies, either
separately or in conjunction with the underlying ETF. (To learn more, check out A
Beginner's Guide To Hedging.)
Cash Management
ETFs can be used to "equitize" cash, allowing investors an easy way to put their
money in the stock market until a long-term investment decision is made. In this
way, investors can ensure they do not miss out on price rises or forego income
while their money is parked temporarily.
Tax-Loss Harvesting
Tax-loss harvesting is a strategy of realizing capital losses in a taxable account,
and then redeploying the sale proceeds among similar investments, leaving the
investor's portfolio largely unchanged. The wash-sale rule prevents an investor
from selling a security at a loss and then immediately repurchasing it by
disallowing the purchase of "substantially identical" securities within 30 days of a
sale. With the availability of a wide variety of ETFs, buying an ETF that is very
similar to the fund or stock being sold is easy. The end result is a portfolio that
closely resembles the one before the capital losses were realized without
invoking the wash-sale rule. (For more on this strategy, see Selling Losing
Securities For A Tax Advantage.)
Completion Strategies
An investor might want to quickly gain exposure to specific sectors, styles or
asset classes without having to obtain the prerequisite expertise in these areas.
As an example, an investor who has no expertise in emerging markets can buy
an ETF based on an emerging market index. Using ETFs allows an investor to
easily fill the "holes" in his or her portfolio.
Portfolio Transitions
Many investors move portfolio assets between different advisors, managers or
funds. In the transition period, the assets might be allowed to sit idle in cash.
ETFs allow investors to keep their assets invested rather than having them
dormant.
Conclusion
Although the first exchange-traded funds (ETFs) were designed to track broad
market stock indexes, since that time, ETFs have been developed to track
industrial sectors, investment styles, fixed income, global investments,
commodities and currencies. ETFs are now available to replicate just about any
index available. All that is required is that there is enough investor interest to
An ETF trades like a stock on a stock exchange. However, like a mutual fund, the
ETF has a structure that pools the assets of its investors and uses professional
money managers to invest the money. Unlike most mutual funds, which are
actively managed, most ETFs are passively managed. An ETF most resembles
an index fund that tracks the same index and its performance should closely
mirror the index it tracks.
An investor who wants to buy ETFs has a myriad of options to choose from in
equities, foreign stocks, fixed income and alternative investment. There are also
many different strategies the investor can employ when using ETFs. Like other
investments, it is important for the investor to evaluate the different options to
ensure the right ETF is chosen for the job.