An ETF is a fund with shares that investors can buy or sell throughout the daily trading session on a stock exchange. Most ETFs available in the United States are index funds, but a few kinds of actively-managed ETFs have been introduced and more varieties will be introduced in the future. Like conventional mutual funds, each ETF holds a portfolio of equity or fixed-income securities or other financial instruments. In addition to these funds a number of other financial instruments like exchange traded notes, grantor trusts and securitized commodity funds are called ETFs. Individually, and in combinations, ETFs offer investors diversification and participation in a variety of investment objectives and strategies.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, especially Chapters 1 & 2.
2. How are ETFs different from conventional mutual funds?
In contrast to conventional mutual fund shares, which investors usually buy from the fund and redeem by selling shares back to the fund, most investors buy and sell ETFs a little like they buy and sell stocks: on the secondary market. An investor can buy and sell ETFs at market-determined prices any time during the trading day. Soon some ETFs will trade at or relative to each day's net asset value calculated for the fund. Almost any kind of order that can be used to buy or sell a stock can be used in intraday trading of ETFs, although simple market orders and limit orders are used most frequently. A buyer or seller of conventional mutual fund shares trades with the fund at the fund's next net asset value (NAV) calculation (usually based on each day's market closing value of the fund's portfolio). Limit orders or other types of orders are not accepted by mutual funds. Individual ETF shares cannot be purchased from the fund and are not redeemable in a trade with the fund. ETF shares must be created and redeemed in what are called Creation Unit Aggregations, commonly from 20,000 to 100,000 fund shares per unit.
Soon a new market in ETF shares will enable investors to buy and sell shares on terms contingent on the ETF's daily net asset value; somewhat, but not exactly, like trading in mutual fund shares.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, especially Chapters 1, 6 & 8.
3. How are new ETF shares created and how are the shares redeemed?
In a creation transaction, each ETF will issue new fund shares in Creation Unit Aggregations to Authorized Participants (broker dealers and other large investors that have signed a Participation Agreement with a fund’s Distributor) who pay for new shares by depositing portfolios of securities designated by the fund that usually resemble the fund's portfolio. Redemption occurs in much the same manner in reverse. To make a redemption, an Authorized Participant assembles the number of fund shares in a Creation Unit Aggregation or a multiple of that number of fund shares and exchanges the fund shares for a basket of securities from the fund portfolio.
The in-kind creation and redemption mechanism has a number of purposes. In-kind transactions do a fairer job of allocating transaction costs among different types of shareholders than the conventional mutual fund cash purchase and redemption process. An investor who buys ETF shares and holds them pays a larger initial transaction cost than the buyer of no-load mutual fund shares, but ongoing shareholders in an ETF will be protected from some tax and transaction costs caused by shareholders entering and leaving a mutual fund. These costs can be a major drain on the performance of mutual funds. Investors who buy or sell ETF shares in less than Creation Unit Aggregations depend on arbitrage forces in the market to keep the price of the ETF shares very close to the per fund share value of the underlying portfolio.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, Chapters 1 & 3.
For information on a specific fund's creation/redemption process see that fund's disclosure documents, usually the Statement of Additional Information (SAI).
4. What kinds of investors typically find ETFs more attractive than conventional mutual funds?
ETFs are usually most attractive to:
Long-term investors who value the ETF's lower operating costs and/or its ability to defer some capital gains tax payments until the investor sells the shares;
Short-term traders who want to trade intra-day rather than at the close or who find their trading is discouraged by conventional funds;
Investors who value the greater transparency of index ETFs which publish any portfolio changes daily; and
Investors who are concerned that many mutual funds do not adequately protect ongoing investors from active fund share traders and market timers.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, Chapters 1, 3 & 4.
5. What kinds of investors have found ETFs less attractive than conventional mutual funds?
ETFs have usually been less attractive to:
Investors who make small periodic investments and who benefit from the conventional no-load mutual fund purchase and sale process with its absence of a trading spread and commission charge;
Traders who are willing to trade at the Fund's net asset value (rather than at intra-day prices) and who would save more money by not paying commission charges and a market spread when they buy and sell fund shares than they would pay in higher expenses within the fund over the period they hold the shares;
Investors who take comfort from the availability of redemption at net asset value and who may be concerned that the ETF shares are not individually redeemable at NAV, making the shareholder dependent on market efficiency to ensure fair pricing for redemption; and
Active fund share traders who can trade mutual fund shares at each day’s closing NAV with their trading costs shifted to the fund’s ongoing shareholders.
The introduction of net asset value-based secondary market trading will make ETFs more attractive to many of these investors.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, Chapter 8.
6. Are ETFs better than mutual funds?
Each investor should evaluate the characteristics and costs of specific ETFs and competitive mutual funds from a personal perspective to reach a decision on which fund is best. We believe most investors who make appropriate comparisons will choose an ETF. The Investment Company Institute reported that as of December 31, 2009, ETFs listed for trading in the United States held total assets of $777 billion. In contrast, mutual funds in the United States held total assets of $11,100 billion. However, since the introduction of ETFs in the United States in 1993, assets in ETFs have grown much faster than conventional mutual fund assets. Most observers agree that ETF assets will eventually exceed mutual fund assets. Obviously that will take a number of years, even at a very high rate of growth for ETFs; but it does suggest that a growing number of investors and advisors prefer ETFs to mutual funds.
ETFs and mutual funds have many features in common. Both invest their assets in portfolios of securities. Each offers shares that can be bought and sold in relatively small transactions, permitting a small investor to obtain relatively low cost diversification, spreading risk over a number of underlying companies and markets. For more information see The Exchange-Traded Funds Manual, 2nd Edition, Chapters 1, 5 & 6.
7. What are the costs associated with Mutual Funds and Exchange-Traded Funds?
Costs that should be fully disclosed by all funds (Expense ratio items):
Other fund expenses
Tax return preparation
Out-of-pocket expenses of service providers
Reports to regulators and shareholders
Index license fees (if applicable)
Marketing expense items paid by the fund (12(b)1 fees)
Portfolio income and expenses not always reported clearly:
Commissions and other direct transaction charges (including “soft dollar” commission premiums) usually buried in fund performance.
Securities lending revenue and expenses (net revenue may be included in investment income).
Earnings credits on balances, interest on overdrafts (usually net lending revenue is included in investment income).
Economic costs that may not have an accounting counterpart (Reflected in performance):
Non-commission transaction costs
Trading (bid-asked) spreads
Transaction costs embedded in pre-announced index changes
For more information see The Exchange-Traded Funds Manual, 2nd Edition, Chapter 6.
8. Who Pays Various Fund Costs?
Conventional No-Load Mutual Funds
All costs of providing liquidity to entering and leaving shareholdersat at net asset value are ultimately paid by ongoing fund shareholders.
Some marketing costs are covered by the management fee.
Conventional Load Mutual Funds
Marketing costs are usually paid by entering (occasionally by leaving) shareholders or, initially, by the management company.
All other costs, including the costs of providing liquidity to entering and leaving shareholders, are ultimately paid by ongoing fund shareholders.
Fully disclosed expenses are paid by fund shareholders except some sales/ redemption costs which are paid directly by Authorized Participants and passed on to fund share traders.
Portfolio expenses and economic costs from sales and redemptions are paid by Authorized Participants and passed on to fund share traders
Other portfolio expenses and economic costs are, appropriately, borne by ongoing shareholders.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, especially, Chapters 1 & 6.
9. What are the most important characteristics I should look for in an ETF?
Essentials that should never be over looked:
Integrity of the fund's management and service providers
Sensible investment strategy or asset allocation fit
Reasonable fee structure relative to the performance expected/delivered
An appropriate cost structure:
Reasonable portfolio turnover and trading costs
Efficient fund operations and marketing
Expense ratio consistent with what the investment process delivers. Expense ratios are very easy to compare and, consequently, are given too much weight in fund comparisons.
For more information see The Exchange-Traded Funds Manual, 2nd Edition, Chapter 6.