The Curious Investor

Now that I think about it, if you define exchange traded fund literally then the term should be an all encompassing reference to any sort of fund that has shares issued on an exchange. But, in our case, we’ll use the term to describe ETFs like those offered as iShares, Powershares, and Proshares as well as a few other outlets that we’ll discuss later on.

So, what is an ETF? ETFs tend to be index linked as opposed to actively managed and are basically placeholders for an original basket of stocks. They are created by a fund issuer who contacts Authorized Participants (usually large institutional investors) who buy a large basket of investments. These baskets are called “creation units” which are then split up into the shares offered on the exchange. Usually something like 50,000 shares of the ETF end up equalling one creation unit. If an investor accumulates a full creation unit worth of shares, he can exchange them for the underlying stocks. (More on this later)

The baskets that ETFs represent are, as mentioned above, typically linked to an index and designed to replicate the performance of it. This could include any number of indexes as simple as the S&P 500 or more interesting ones including international stock exchanges, commodities, and bonds. ETFs give retail investors access to markets and asset classes that they usually would not have access to. Furthermore, they offer the safety of diversification within these asset classes as ETFs typically represent an index with many stocks in them. Furthermore, compared to open-ended mutual funds, ETFs typically have very low expense fees, .1%-1%, whereas open-ended mutual funds can have fees from 1% to 3%.

Another benefit of ETFs is that they are continually priced and essentially trade like stocks which allows investors to play their exposure throughout the day as opposed to having to buy and sell a mutual fund at closing. Further, since the investor is technically only involved in one security, that of the ETF, there are tax and commissions advantages to ETFs. First, some online brokers have stopped charging commissions for ETFs. Second, as far as taxes go, ETFs only realize capital gains when you sell your shares. A mutual fund will be taxed on its own capital gains if other investors redeem their shares as any capital gains the mutual fund gets must be redistributed to its holders. Both ETFs and mutual funds suffer from taxation when the fund has to be rebalanced to better track the index and some have argued that ETFs have to do this more often than mutual funds and as a result ETFs typically have poorer tax treatment for their dividends.

The key thing to remember throughout all of this is that ETFs are meant to be compared to open-ended index tracking mutual funds. In this regard, they are often far superior. Comparing them, however, to actively managed mutual funds is a whole different story. The two do not share the same role in your portfolio allocation. ETFs allow diversification and access to targeted markets. They do not offer inherent risk management or any sort of implied returns. They are just dumb, plodding funds designed to return whatever their index returns. An actively managed mutual fund, one would hope, offers the security of a professional managing the risk of the portfolio as well as some sort of implicit goal of regular returns.

Also, as with any fund and as with anything traded on an exchange, there are some risks involved with ETFs. First, tracking risk. As there’s no way to create a basket to exactly match an index, all indexed funds suffer some tracking risk. Usually, a period of a few months, indexed funds perform nearly equivalently to their analogous index. But, from day to day, it is possible to see some deviation. Second, is market risk. While the exchangeability of creation units by authorized participants helps to limit the risk of an ETF trading at a large discount or premium to its underlying value, it can happen. If there is a lot of demand for shares of the ETF or a lot of selling pressure, you can see an ETF start to deviate from its net asset value. Usually, this won’t last very long as deviations from net asset value will be quickly arbitraged by institutional investors. An example of this would be if the ETF begins to trade at a premium, an investor could short sell the ETF, then buy all all the stocks the ETF holds and exchange it for shares of the ETF to use to cover the short. Since the stocks will cost less than the ETF (the result of the premium), the institutional investor will pocket the difference as riskless (arbitrage) profit. Take some time and think about how to do this should an ETF trade at a discount, it’s pretty much the same but a good exercise. An important thing to consider is volume of trading on ETFs. Thinly traded ETFs tend to be more prone to suffering market risk while high volume ETFS will generally stay close to their NAV.

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