Exchange Traded Funds (ETFs)

CFA Level 1 - Alternative Investments

Exchange-traded funds (ETFs) are investment companies that are technically classified as open-end companies (although they are not considered to be or allowed to call themselves mutual funds). These are index funds that mirror the composition of standard indexes such as the NASDAQ 100 or the Russell 2000; it may also include broad market, sectors, single countries or regions as well as fixed income. They allow investors to buy or sell exposure to an index through a single financial instrument. They are like traditional funds in that they are a pool of money to be invested, however, unlike traditional funds, ETFs can be sold short or margined in the investor's account. ETFs also differ from traditional open-end companies because ETF shares trade on a secondary market (as do closed-end funds) and are only redeemable in very large blocks (50,000 shares for example).

Relatively new and somewhat less intuitive than other investment companies, ETFs are actually certificates that grant ownership over part of a basket of individual stocks. ETFs trade at prices that closely match their underlying assets and unwind when investors no longer want them. Fund Managers are vital to the process: they must develop a plan for operating the ETF and have the plan approved by the SEC. The ETF plan must explain the ETF's composition, identify other firms involved in the fund and describe how the fund will operate and how redemption will occur.  

ETF Managers
The fund manager instructs pension funds, which control huge securities portfolios, to loan the stocks necessary for creating the ETF index of stocks. (The pension funds get a small amount of interest in return.) Today, the role of ETF manager is usually left to the very largest institutional money management firms with experience in indexing. The fund manager takes a small portion of the fund's annual assets as their fee. An authorized participant, also referred to as a market maker or specialist, assembles the appropriate basket of stocks and sends them to a custodial bank. The custodial bank is responsible for ensuring that the basket does, in fact, mirror the requested ETF. It forwards the ETF shares on to the authorized participant. The custodial bank holds the basket of stocks in the fund's account for the fund manager to monitor.

The Depository Trust Clearing Corp., the same U.S. government agency that records individual stock sales and keeps the official records of these transactions, records ETF transfers of title just like with any stock. It provides an extra layer of assurance against fraud.

Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it in the open market. From then on, ETF shares are sold and resold freely among investors on the open market. The authorized participant derives a profit from the difference in price between the basket of stocks and the ETF and on part of the bid-ask spread of the ETF itself.

Redeeming ETFs
To effect a redemption, an authorized participant buys a large block of ETFs on the open market and sends it to the custodial bank. In return, the participant gets back an equivalent basket of individual stocks, which are then sold on the open market or returned to the pension funds that originally owned them. Competition tends to keep ETF prices very close to their underlying net asset value (the value of component stocks). 

 For further reading on exchange traded funds, refer to our Introduction to Exchange-Traded Funds article.


Advantages and Risks of ETFsETFs differ from traditional mutual funds in a number of ways. 

• Trading: Buy and sell orders for traditional mutual funds are taken throughout the trading day but the transactions actually occur at the close of the market. It's at that point that the NAV is calculated (The sum of the closing day prices of all the stocks contained in the fund is divided by the number of shares in the fund.) ETFs trade continuously and allow an investor to lock in a price for the underlying stocks immediately.
• Fees: ETFs are economical to buy compared to most mutual funds. Annual fees are as low as .09% of assets compared to the average mutual fund fees of 1.4%. Discount brokerage options mitigate the transaction costs associated with trading ETFs. They can be margined and options based on them allow for various defensive (or speculative) investing strategies. 
• Safety: The risk and safety associated with ETFs is considered to be equivalent to the risk and safety of the stock certificates themselves. 

Advantages:

1. Allows investors to diversify very easily by buying or selling the shares. As mentioned earlier, an ETF can cover an index no matter how big or small that index is.
2. They trade on an exchange and can be sold short or margined.
3. ETFs trade throughout whole day, so prices are always updated, while mutual funds only have a price at the close of the day.
4. Trading futures and options on ETFs helps manage the risk involved in trading ETFs.
5. ETF holdings are transparent. The sponsor posts the fund's holdings daily, which should mimic the index, while a mutual fund may disclose the fund's portfolio composition only on a yearly basis.
6. They are cost effective, don't charge load fees and are passively managed, while mutual funds may have substantial fees and are often actively measured, which increases the expense ratio compared to ETFs.
7. Their structure prevents any type of premium or discount forming because of the arbitrage effect of the futures and options on these securities. A closed-end fund, on the other hand, has a limited amount of shares, which can cause it to become overpriced as a result of its supply and demand attributes.
8. ETFs mitigate capital gains exposure.
9. Dividends are reinvested immediately for open-end ETFs.

Disadvantages/Risks:

1. In many countries, the basket of securities that the ETF tracks may be limited.
2. Many investors do not need the intraday trading activity of the security.
3. Bid/ask spreads may be large because of the light trading that may occur in specific ETFs.
4. Due to their size, large institutions may want to invest directly in the index or actively invest in the index, which could lead to lower cost and a better tax situation.

The following article provides further details about the advantages to ETFs: Advantages of Exchange-Traded Funds.

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