Using Exchange Traded Funds – Part 1

In the last four years or so, there has been explosion of newly created exchange traded funds (ETFs) in the financial marketplace. What are these investment products, and how are they different from the more familiar mutual funds?

Figure 1 shows the growth in both the number of exchange traded funds available and the amount of money invested in them.  Although the ETF world is still dwarfed by the $11 trillion mutual fund industry, ETFs have clearly taken off on a growth spurt.  Exchange traded funds were originally introduced to provide an investment vehicle with certain advantages over mutual funds.

In its simplest form, an ETF owns a “basket” of securities.  The securities are selected according to specified criteria; most often, the basket mirrors the stocks in a market index.  ETFs for asset classes other than stocks also exist, but the lion’s share of ETFs are linked to one of a growing number of stock indices.

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A market index describes a portfolio of securities that represents the behavior of a certain market (e.g. large capitalization stocks, value stocks, intermediate-term government bonds, etc.).  The first ETF, developed by the American Stock Exchange in 1993, was the Standard & Poor’s Depository Receipt, or SPDR (pronounced “spider”).  Given the ticker symbol SPY, this was the first of the family of ETFs that is now licensed to and marketed by State Street Global Advisors.  This ETF invests in the stocks in the S&P 500 Index and is the largest exchange traded fund, with net assets of about $67 billion.

ETF Characteristics
The world of ETFs is changing rapidly, but there are a number of characteristics that are usually true of exchange traded funds.

Trading Units
ETFs are established by large financial institutions that create large blocks of ETF shares.  The institutions typically buy securities from the appropriate index and then exchange them for blocks of ETF shares.  A block can usually be directly redeemed for the appropriate number of underlying stock shares.  This is one of the key features of the ETF: the underlying stock “basket” is readily interchangeable with an ETF block.  This has important tax consequences that I’ll discuss in the next post on this topic.

Trading ETF Shares
Individual (“retail”) investors can purchase shares from an ETF block on a stock exchange through a broker.  ETF shares thus have properties similar to shares of individual stocks, because they

  • trade for a market price that is updated continuously during the day
  • can be purchased on margin
  • can (often) be purchased via options
  • can be sold short

This is different from typical (“open end”) mutual funds shares, which trade at net asset values determined at the end of each trading day and which are purchased from or redeemed by the mutual fund.

Liquidity
Market liquidity refers to the ability for an asset to be purchased or sold quickly during normal market trading hours with minimal price concessions being required to accomplish the sale.  A financial asset is liquid if there are buyers and sellers readily available at all times.  Because ETF shares can be bought and sold all day (and because ETF blocks can be exchanged directly for underlying stocks), ETFs tend to be very liquid.  In practice, the liquidity of a specific ETF will depend on the liquidity of the underlying securities in its “basket.” The largest stock ETFs are extremely liquid.  Many of the largest ETFs can even be purchased like stocks in after- or before-market trading (i.e., outside of regular stock exchange trading hours).

Usually Passive Index Funds
Until this year, ETFs were exclusively index funds, meaning that all of them were passively, rather than actively, invested.  In practice, some of the more unusual indexes are based on selection criteria that result in stocks moving in and out of an index relatively frequently, so such indexes, and the ETFs linked to them, are really “pseudo-active.”

At the beginning of this year, the SEC began permitting the creation of actively-managed ETFs.  Such funds have been required to fully disclose their investment holdings at all times, a practice referred to as transparency.  The SEC has also indicated that it might, in the future, permit the creation of ETFs which do not disclose their holdings fully at all times.

Transparency
As noted, this refers to the fact that the holdings in ETF portfolios are disclosed publicly at all times.  This is different from a typical mutual fund, which only discloses the contents of its portfolio on a quarterly basis.

Transparency is one characteristic that causes the price of an ETF share to remain very close to the value of the underlying securities in the ETF.  This is different from a closed-end mutual fund, which can often trade for price that is significantly less (“discount”) or more (“premium”) than the securities held in the fund.

Low Cost Structure
ETFs, like mutual funds, incur management costs.  Since most are passively managed, their expense ratios are low and are usually lower than mutual funds investing in the same index.

Because investors purchase and sell ETFs through brokers, they may incur brokerage costs in ETF transactions, although some brokerages offer minimal-cost or free ETF trades in some cases.  If the transaction cost are kept low, ETF expenses can be very competitive with comparable mutual funds.

This almost covers the general characteristics of ETFs; I’ll continue explaining these in the near future.

To read part 2 of this series on ETF’s click here:

About the author

Thomas Fisher, CFP®

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