Exchange-Traded Funds

Exchange-traded funds (ETFs) are investment companies that create and sell shares in a fund that represents a beneficial interest in the holdings of the fund, which can include stocks, bonds, and other securities, and these ETF shares are traded on a stock exchange, and bought and sold through a broker-dealer, just like a stock. It is not a stock, however, because it does not represent ownership in a company.

Presently, ETFs seek the returns of a particular index by either buying all the securities in that index or by buying a representative sample. Commonly, the fund also buys these securities in proportion to their weights in the index, although there are exceptions to this. Its main advantages over other mutual funds are lower fees and greater tax efficiency. Exchange-traded funds evolved from closed-end funds and American Depositary Receipts.

The main assets of the fund are its securities, and the net asset value (NAV) of the fund is the total market value of the fund's securities, plus any other assets, such as cash, minus its liabilities, then dividing the result by the total number of ETF shares outstanding. The shares of an exchange-traded fund are derivative securities, because their price is closely correlated and derived from the prices of the securities in the fund.

Net Asset Value (NAV) Formula
Net Asset Value (NAV) = Value of ETF
Number of Shares
Net Asset Value (NAV) Example
$100,000,000 total fund value
= $10 per share

Exchange-Traded Funds Versus Mutual Funds

Mutual funds and exchange-traded funds are similar, in that they both represent a basket of securities that lowers volatility and risk, but they have different advantages and disadvantages for investors.

Exchange-traded funds (ETFs) are investment companies that create and sell shares in a fund representing a beneficial interest in the holdings of the fund, which can include stocks, bonds, and other securities, and these ETF shares are traded on a stock exchange, and bought and sold through a broker-dealer, just like a stock.

How an Exchange-Traded Fund Works

An exchange-traded fund is a mutual fund and is regulated as such by the Securities and Exchange Commission (SEC). It is closely related to the closed-end mutual fund.

To start an ETF, an investment company must

The Authorized Participants, also called creation unit holders, then delivers the securities to the ETF sponsor, who then returns to the Authorized Participants a creation unit of ETF shares, which usually consists of 50,000 shares or a multiple thereof. The Authorized Participants can either keep the shares or sell them in the retail market. The Authorized Participants can also redeem the ETF shares by delivering them, in creation units, to the ETF sponsor in return for the securities represented by those shares. To reduce taxes for the fund, the ETF sponsor returns securities with the lowest tax basis to the Authorized Participants, so that when the ETF sponsor does have to sell some securities in the future, the securities remaining with the ETF sponsor will have a higher tax basis that will generate smaller capital gains for the fund. Note that the exchange of ETF shares and the securities they represent between the Authorized Participants and the ETF sponsor is an in-kind exchange — there is no exchange of cash. This also lowers taxes for the ETF sponsor, thereby lowering the fund's fees.

Diagram showing how an exchange-traded fund (ETF) is created, showing the transactions between the ETF sponsor and Authorized Paritcipants.

Retail investors have no relationship with the ETF sponsor. Only Authorized Participants offer ETF shares for sale on the stock exchanges. A holder of ETF shares does not own a portion of the securities held by the ETF sponsor, but owns a portion of the creation unit held by the Authorized Participants.

When the composition of the index that the ETF is tracking changes — for instance, when stocks are added or deleted from the index — the ETF sponsor notifies all Authorized Participants of the change. When a security is added to the index, the Authorized Participants deliver the newly added security to the ETF sponsor, and the ETF sponsor returns any securities that were deleted from the index to the Authorized Participants.

Because both the ETF shares and the securities composing the fund trade independently of each other, there is usually a price discrepancy between the ETF share price and the NAV. When the ETF share price is higher than its NAV, the ETF is said to be selling at a premium; when it is lower, it is selling at a discount.

Discount | Premium Percentage Formula
Discount | Premium
(Discounts < 0, Premium > 0.)
= Market Price - NAV
Discount | Premium Example
$11.92 Market Price - $12.27 NAV
$12.27 NAV
= -2.85% Discount

To minimize this discrepancy between the NAV and the ETF share price, an exchange-traded fund provides for an arbitrage procedure, using the same procedure used in creating the fund. Authorized Participants can exchange either the shares of the ETF for its underlying securities, or vice versa, whichever yields a profit for the Authorized Participants. This exchange is in-kind, trading creation units of ETF shares for the securities.

Thus, if the share price of the ETF is significantly lower than its NAV, then the securities represented by the ETF shares can be sold for more money than needed to buy the ETF shares. So an Authorized Participant can buy ETF shares on the open market, exchange them for the underlying securities, then sell the securities for a profit. When the Authorized Participant buys the ETF shares, this increases demand for the ETF shares, and thus, raises its market price; when the Participant sells the securities, this lowers the demand for those securities, thereby lowering their prices and narrowing the gap between the price of the ETF shares and the prices of the underlying securities.

If the ETF shares are selling at a premium to its NAV, then the Authorized Participant can buy the securities in the open market, exchange them for creation units of ETF shares directly from the fund, thus creating more shares, then sell them in the market for a profit. This is how ETF shares are created and destroyed, like the procedure for American Depositary Receipts, which are certificates representing an interest in the securities of a foreign company. In fact, the very first ETF, first marketed in January, 1993, was called the Standard and Poor Depositary Receipts, which represented an interest in a fund that tracked the stocks that compose the S&P 500 stock index. This buying and selling of related securities to profit from the price differences is called arbitrage.

However, there will be some difference between the NAV of an ETF and its share price, because market demand will differ by at least a small amount at any time, so the price discrepancy must be great enough for a substantial arbitrage profit that will cover transaction costs and pay a risk premium, since there is some risk for Authorized Participants in exchanging ETF shares for its underlying securities. Market prices can change quickly, and they may change unfavorably in the time that the Authorized Participant takes in completing the arbitrage.

This provision for arbitrage is what differentiates ETFs fundamentally from closed-end mutual funds. A closed-end mutual fund is much like an ETF — it sells shares representing a basket of securities on a stock exchange, and trades just like a stock, but, because it has no legal provision for exchanging the shares of the fund for the securities after the fund is created, the fund share price frequently deviates significantly from the fund NAV.

Another common difference between closed-end mutual funds and ETFs is that, often, closed-end funds use leverage in buying its portfolio. While this may increase profits if the managers guess right, it can also cause greater losses if they are wrong. Interest paid on the borrowed money will also increase expenses.

Legal Structures of Exchange-Traded Funds

Exchange-traded funds have 3 main legal structures, which somewhat determines how they operate. An ETF organized as an open-end mutual fund or a unit investment trust are required to register as investment companies under the Investment Company Act of 1940.

ETFs Organized as an Open-End Fund

An exchange-traded fund organized as an open-end investment company must supply investors in the secondary market with a Product Description, or profile, which summarizes key information contained in the fund's prospectus, such as the fund's investment objectives, principal investment strategies, principal risks, performance, fees and expenses, identity of the fund's investment adviser, investment requirements, and other information, and informs investors on how to obtain a prospectus. Authorized Participants automatically get a prospectus.

Statements of additional information (SAI) must be provided upon request free of charge. The SAI generally includes the fund's financial statements and information about:

The open-end fund must also provide shareholders with annual and semi-annual reports, 60 days after the end of the fund's fiscal year and 60 days after the fund's fiscal mid-year. These reports contain a variety of updated financial information, a list of the fund's portfolio securities, and other information.

Open-end ETFs reinvest dividends as soon as they are received and are paid out quarterly. To increase income, the fund can include derivatives in its portfolio and lend its securities.

ETFs Organized as Unit Investment Trusts

Although ETFs organized as unit investment trusts (UIT) track an index, they are restricted as to security weightings. These restrictions include the following:

Dividends are paid quarterly, but are not reinvested. The best example of this kind of trust is the NASDAQ-100 Trust, which sponsors the QQQQ ETF and is currently the most actively traded ETF.

Exchange-Traded Grantor Trusts

The exchange-traded grantor trust is not a registered investment company, and is not an actual ETF. Investors have voting rights in the companies composing the fund, and the investors can create or redeem shares in round lots of 100. Dividends are not reinvested and are paid immediately to investors. Holding Company Depositary Receipts (HOLDRs), a proprietary product of Merrill Lynch, is an example of the exchange-traded grantor trust. HOLDRs generally cover a narrow sector of the market, such as the Biotech (BBH) or Broadband (BDH) HOLDRs.

The portfolio of the exchange-traded grantor trust does not change, and, thus, cannot be rebalanced, leading to less diversification as some of the companies grow larger than the others in the portfolio, nor can stocks that fit the trust's profile be added later. Thus, it is inevitable that, over time, these trusts will become less diversified. For example, Internet Holding Co. Holdrs Trust (HHH) has more than 50% of its portfolio invested in just Yahoo and eBay, but none in Google, because Google had it's IPO after this HOLDR was created.

Buying and Selling ETF Shares on an Exchange

Most ETF shares trade on the American Stock Exchange, which is now part of NYSE Euronext, with an increasing number trading on the NASDAQ exchange. Because ETF shares trade on an exchange, they must be bought and sold through a broker. Unlike the shares of an open-end mutual fund, fractional shares cannot be purchased, nor can dividends be reinvested easily and cheaply, and brokerage commissions make it more expensive to invest small amounts frequently, although many brokerages are now eliminating commissions even on odd-lot sales. Thus, dollar cost averaging is more expensive.

Buy and sell orders for ETF shares can be conditional, such as limit orders or stop loss orders — or they can be any other kind of order that can be entered for stocks. They can also be bought on margin.

ETF shares can also be sold short, and they are not subject to the short sale rule, which requires that a short sale cannot be executed on a stock unless the last changed price was an uptick. This SEC rule was designed to prevent short sellers from driving the price of a stock down by their very activity. However, short sellers cannot drive down the price of an ETF by more than a small amount because ETF shares are based on an underlying basket of securities, and the price of these securities depends on the instantaneous supply and demand for each security. If the price of the ETF shares drops significantly below the NAV of the fund, then Authorized Participants will buy up the ETF shares to exchange them for the underlying securities. This will increase demand for the ETF shares, which will increase their price, and the demand for the ETF shares can potentially squeeze the short sellers, especially since many ETFs do not have that many shares outstanding. Selling ETF shares short is a popular hedging technique.

Exchange-Traded Funds as an Investment

Exchange-traded funds provide diversification for small investments, moderating both risks and returns.

ETFs have lower expenses than mutual funds because most ETFs are based on an index, and thus, are not actively managed, thereby reducing management fees. Note, however, that this is only a present characterization of most current ETFs, and is not a necessary condition. There are new ETF funds being created continually, and some of these may have active management and charge higher fees. Administration fees are also less because there is less interaction with individual investors than with an open-end mutual fund. There is no need to send individual investors monthly statements, for instance. Their ETF holdings will be in their monthly brokerage statements — just like any stocks they would own. In fact, a primary advantage of owning ETFs is that they can all be listed on one brokerage statement. In contrast, each mutual fund company sends their own statements. According to Morningstar, which started rating ETFs in 2006, the average annual fees for equity ETFs was 0.43%, while equity mutual funds averaged 1.45%.

An ETF fund also saves on commissions and fees associated with buying and selling securities, since it is the Authorized Participants who buy and sell the securities, and when the fund exchanges securities with Authorized Participants, the fund transfers its securities with the lowest cost basis, thereby lessening any capital gains and its associated tax when the fund does have to sell securities.

It is easy to invest in specific assets, such as stocks, bonds, or commodities, for instance, by buying multiple ETFs, each devoted to a specific asset class, which makes it both easier to diversify assets with low market correlation, and to rebalance those asset allocations as needed.

The greatest reduction in capital gains taxes results from not having to redeem shares to investors who want to cash out. When an investor in an open-end mutual fund wants to redeem his shares, he sells them back to the fund in exchange for cash. Large redemptions, especially in market downturns, can force the fund to either sell stocks for the cash, which generates a capital gains tax for everyone remaining in the fund, or the fund must keep a significant amount of cash for such redemptions, meaning it can't be invested in stocks, or other securities that usually earn better returns than the prevailing interest rate. An investor of an ETF simply sells his shares to another investor on an organized exchange, just as he would sell a stock. This is particularly important during market panics, when many investors start redeeming their shares in a regular mutual fund, which forces the fund to sell more securities while the market is down to generate the cash to pay investors cashing out, and this can increase taxes or losses for the rest of the remaining investors.

Another advantage of ETFs is that the distribution of dividends and capital gains, while taxable, does not affect the cost basis of the ETF shares, thus making tax computation easier.

Tax Tip: Avoid the Wash-Sale Rule with Exchange-Traded Funds

The wash-sale tax rule prevents you from taking a tax deduction for a loss on a security if you buy that same security, or one that is substantially similar, within 30 days, either before or after the sale.

If you want to take a tax loss on a security, even an ETF, you may be able to do so and still avoid the wash-sale rule by either buying an ETF in the same sector as the stock you sold, or buying another ETF from a different company that covers the same market sector or the same index as the ETF you sold.

The IRS defines a substantially similar security as buying the same security, or buying a security convertible to the security, such as a call, or a convertible preferred stock or bond. So, a preferred stock is different from the common stock of the same company only if it cannot be converted to the common stock. So buying a different ETF that covers the same sector would avoid the wash sale rule, because the ETF is not the same security as the previous one, and it is not convertible to it. Likewise, if you want to sell an ETF to take a tax loss, buy a different ETF based on the same index, because the one ETF is not convertible to the other, even though they are both based on the same index. Ergo, in this scenario, losses can be deducted on the sold ETF.

ETF Types

Recently, due to their popularity, ETFs based on various investment strategies have proliferated, even allowing small investors to invest in the risky commodities market.

Virtually all ETFs are based on indexes. However, because funds based on the better known indexes are usually market-weighted, they may not be as diversified as one may believe, since these indexes have a greater weight in large-cap companies. Over the long haul, this could also reduce returns, because larger companies do not have the growth potential of smaller companies. Thus, greater diversification can be achieved by investing in a variety of ETFs with a low or even negative correlation with each other.

Major Index ETFs

Major index ETFs were the original ETFs. These ETFs track indexes such as the S&P 500 or NASDAQ 100. In fact, the first ETF, first appearing in January, 1993, was the Standard and Poor's Depositary Receipts (SPY), usually abbreviated as SPDR and called “spiders”. Another ETF based on the S&P 500 is the Rydex S&P Equal Weight (RSP) which gives equal weight to each company listed in the index, instead of a weight based on market cap. Thus, GE constitutes only 0.2% of the ETF's underlying securities, whereas in a market cap weighted ETF, it would compose more than 3%.

Other popular ETFs based on major indexes are the Diamonds (DIA), which tracks the Dow Jones Industrial Index, and the NASDAQ 100 Trust Shares (QQQQ), called qubes, one of the few ETFs that trade in the NASDAQ Stock Exchange. Qubes are also the most heavily traded ETF.

Style ETFs

Most ETFs based on style are divided into growth and value companies, although finer distinctions might be made. For instance, most of the Russell Indexes are further divided into sub-indexes of growth and value companies, and most of these indexes have ETFs tracking them, such as the iShares Russell 2000 Growth (IWO) and the iShares Russell 2000 Value (IWN) ETFs.

Bond ETFs

Bond ETFs are not as advantageous over bond mutual funds. Fees are low, but so are many mutual bond funds, such as the Vanguard Total Bond Market Index (VBMFX) at 0.2%. Bond funds don't turnover nearly as fast as stock funds, and redemptions are much less for bond funds. Therefore, the capital gains are small even for a mutual fund. Bond mutual funds might be a better investment than bond ETFs because of greater inefficiencies in the bond market that allow some bond mutual fund managers to consistently beat the indexes.

Microcap ETFs

Micro-cap stocks have a low correlation with large cap stocks, and thus, micro-cap ETFs can diversify a large-cap fund with stocks with an overall greater growth potential. Expense ratios are around 0.6%. However, because of less liquidity of the underlying stocks with the associated larger spread between bid and ask prices, there can be a larger deviation between NAV and ETF share price, because Authorized Participants need a larger spread between the 2 prices to make creations or redemptions of ETF shares profitable. Some examples of Microcap ETFs: iShares Russell Microcap Index (IWC), PowerShares Zacks Micro Cap Portfolio (PZI), and First Trust Dow Jones Select MicroCap (FDMDM).

Dividend ETFs

Some ETFs focus on stocks that pay dividends. A 2003 tax cut made dividend-paying stocks more attractive to many investors, reducing the maximum tax rate on certain qualifying dividends to 15%. Many of these ETFs invest in stocks of foreign companies because they often pay a larger dividend. Dividends in countries like Belgium, Finland, Italy and Australia offer an average dividend yield of 3% to 4% or more versus 1.8% for the U.S.

However, for foreign stocks to qualify for the tax break, the companies must be in countries with comprehensive tax treaties with the U.S., trade on U.S. exchanges or be incorporated in a U.S. possession. A disadvantage that may offset the higher dividend is that many foreign countries withhold tax — often about 15%— on dividends paid to U.S. investors. Investors who hold a foreign dividend-focused fund in a taxable account can claim a foreign tax credit on their U.S. tax return for the foreign tax paid. This credit, however, is not available if the fund is in a tax-deferred account, since if no federal taxes are paid, then no credit can be taken.

American stocks paying high dividends are concentrated in a few sectors, such as utilities and financials, while foreign stocks that pay high dividends are more diversified, including media and technology companies. Thus, the foreign market and the different sectors paying high dividends helps to further diversify dividend ETFs.

WisdomTree Investments, Inc., for instance, is offering ETFs composed of foreign dividend paying stocks. These ETFs are weighted by dividend amount rather than by market cap.

Another example of an ETF that focuses on income is the Thornburg Investment Income Builder A ( (TIBAX), which holds both bonds and stocks with dividends.

Leveraged ETFs

Not all ETF's are based on stocks. Some are based on derivatives, such as options and futures. The use of derivatives allows leveraging to do a multiple of what the market index does. Leveraged ETF's seek to make 2 or 3 times the return of their target index, while leveraged inverse ETF's seek to earn a multiple when the target index declines. Leveraged ETF's are generally used for short-term trades — not as long-term investments, since markets go up and down, so gains and losses are both amplified. However, short-term trades cause extensive buying and selling of the securities as arbitrageurs try to take advantage of these differences in prices, which some critics contend causes wild market gyrations at the start and end of the trading day.

Synthetic ETFs

Sometimes an ETF is not based directly on the underlying asset, because of the cost of actually owning the asset is high or because it is not possible to own the asset, such as an ETF based on the volatility index or on a stock index. Instead, a position is synthesized based on the value of a futures or derivatives contract, which in turn, is based on the tracking asset, creating what is known as a synthetic ETF.

Note, however, that owning an ETF based on a futures contract may be risky and not very profitable if the futures contract exhibits contango, where the price of short-term contracts is lower than longer-term contracts. Because an ETF is a perpetual security while a futures contract has a limited lifetime, it is necessary for the ETF sponsor to continually roll over the futures contract to later settlement dates. When a futures contract is often in contango, then the ETF sponsor must sell futures contracts nearing settlement at a lower price than the contracts that settle later, lowering profits or increasing losses than would otherwise occur if the asset were owned directly, such as with natural gas.

Other Types

There are many other ETFs with different investment objectives, and with the current popularity of ETFs, more are sure to come. Some funds, for instance, track nanotechnology companies or homebuilders, or target specific countries or regions, such as Australia, Austria, or South Africa. Some examples are the PowerShares Water Resources Portfolio (PHO), based on the Palisades Water Index, focuses on companies dealing with water, and PowerShares Dynamic Food & Beverage Portfolio (PBJ) holds the stocks of food and energy companies. The streetTRACKS Gold Shares ETF (GLD) tracks the price of gold. The Vanguard Energy ETF (VDE) focuses on energy companies, with a large weight in oil companies, and the PowerShares WilderHill Clean Energy Portfolio (PBWBW) focuses on companies developing renewable energy sources. There is even a fund tracking short-term U.S. Treasuries, the iShares Lehman 1-3 Year Treasury Bond Fund (SHY).

Additional Topics

New ETF Products are Created and Test Marketed in Europe

ETFs were first sold in Europe in 2000, 7 years after their introduction to the United States market, but because of less regulation, specifically, not requiring to register new ETF funds under the Investment Company Act of 1940, many new ETF products are first developed and test marketed in Europe before being sold in the much larger United States market.

Examples of products first sold in Europe, and then the United States include ETFs based on leveraged funds, oil, and gold. Products still being tested in Europe include active management funds, capital-protection funds, and commodities like aluminum and wheat.

Custodian Banks — Actively Managed Exchange-Traded Funds

Global Custodian Banks -

Custodian banks provide custodial services, including trade processing and clearing, and fund accounting and administration, for investment companies, brokerages, and institutional investors. With companies becoming more global, custodian banks have expanded their services to include foreign-exchange trading and securities lending. A global custodian bank can help with the different regulations and accounting practices in other countries, as well as currency conversion. Custodian banks are also handling different assets, including derivatives, real estate, and private equity.

Small Firm's Big Goal: A Sea Change in ETFs -

The main reason why ETFs are not actively managed is because the fund manager must reveal what he is buying or selling, thereby allowing traders to trade ahead of the ETF company for greater profits and at a greater cost to the company. This article is about a company trying to circumvent that problem to create the 1st truly actively managed ETF. The solution to the problem was not revealed, however. However it will be done, it will certainly increase expenses above the typical ETF.

New Exchange-Traded Funds (ETFs) Indicate a Market High?

New exchange-traded funds, especially sector and industry funds which make up more than 40% of all ETFs, are created when there is the most market interest and the market is peaking. Therefore, there is a good possibility that the ETF will decline shortly thereafter. One market manager said that when a new ETF comes out, he looks for securities in that ETF to sell.