Exchange Traded Funds

Exchange-Traded Funds are investment vehicles listed on the stock exchange which provide easy access to asset classes by tracking the performance of underlying indices. They are an important asset in portfolio management.

Exchange-Traded Funds (ETFs) are one of the options available to investors in the investment universe. These are investment vehicles structured like funds and provide access to various asset classes like stocks, bonds, currencies, or commodities. Exchange-Traded Funds usually track an index representing the aforementioned asset classes, though there are actively managed ETFs available in the market. Even the index tracking ones are not completely passive, though, as the underlying indices are rebalanced periodically. Let’s look at how ETFs are created.

Creation and Structure of Exchange Traded Funds

Exchange-Traded Funds are created by institutional investors known as authorized participants. They are the sole entities that can make or redeem an ETF. While creating the instrument, authorized participants design a portfolio of the required securities in decided proportion. For instance, if the ETF in question is an equity index tracking vehicle, the authorized participant will keep underlying stocks in the same proportion as in the equity index. They’ll then give this basket to the fund provider and receive equivalent ETF shares in return.

It is important to note that authorized participants only deal in large chunks of the basket of securities when dealing with the fund provider. These chunks are known as creation units. These participants also do the redemption in similar-sized creation units.

Exchange-Traded Funds are pools of securities whose ownership units are known as shares in terms of structure. Shareholders are indirect owners of the underlying assets of an ETF, and the said shares are the proof of this ownership. An ETF can take the structure like that of a corporation or a trust, which depends on the structures permitted by the country of domicile. For instance, ETFs are mostly structured as open-end management investment companies in the US.

Let’s now see the basic properties of ETFs and the types that are available in the market.

Properties and Advantages of Exchange Traded Funds

Listed As Shares

Exchange-Traded Funds are listed on stock exchanges and can thus trade like individual stocks. Their prices change throughout the day, also similar to stocks. Like some other fund vehicles, a Net Asset Value (NAV) is also calculated at the end of a trading day. In some cases, the fund house may also provide a real-time indicative NAV.

Arbitrage Opportunity

For large investors who have the capacity to buy creation units directly from the fund provider, ETFs can provide an arbitrage opportunity as depending on the level of demand for the fund, its market price can be higher or lower than its indicative NAV.

Interesting Investment Prospect

Even though most ETFs track an index, their sheer breadth and uniqueness of the underlying indices can make them interesting investment prospects. The underlying indices can be publicly available or privately constructed, focused on a particular country or investing across a region, and may provide access to a particular asset class or be a blend of asset classes.

Exposure to Focused Asset Class

As far as the major advantages of Exchange Traded Funds are concerned, the most prominent is helping investors test the waters of the asset classes they are interested in. For instance, an ETF focused on emerging markets can be the starting point of exposure to stocks or bonds from the relatively risky analytical group for a US investor.

Cheaper in Comparison with MFs

Further, since the services of a portfolio manager are not availed, such exposure will be cheaper than that offered by a mutual fund.

Disadvantages of Exchange Traded Funds

Though Exchange Traded Funds come with several advantages, they are not free of faults.

Tracking Error

Tracking errors can be a prominent disadvantage. Though no ETF can completely replicate its underlying index, a noticeable tracking error can be witnessed in strategies that may not allow complete replication of the index due to liquidity issues, like leverage strategies or ETFs investing in commodities.

When choosing ETFs that mimic an index, tracking error becomes an essential consideration for investors. The lower the tracking error, the better a job the particular fund is doing in replicating the performance of the underlying index.

Illiquid due to Small Size

The small size of an ETF can be a disadvantage as well. For relatively small funds, it may be difficult to completely replicate an index, which may increase its tracking error and make it illiquid, especially in times of distress.

Tax Implications

Investors need to exercise caution for ETFs that invest beyond the traditionally popular asset classes of equities and fixed income. Apart from an increased tracking error, tax implications may be high at best or unclear at worst, which may have a sizable impact on returns.

Types of Exchange Traded Funds

Exchange-Traded Funds can be of many types and provide exposure to several assets classes, geographies, and market capitalizations.

Equity ETFs

Fixed Incomes ETFs

Commodity ETFs

Currency ETFs

Speciality ETFs

Actively Managed ETFs

Examples of ETFs available to US investors

The SPDR S&P 500 ETF (SPY) is by far the largest and most popular ETF (in terms of trading volume) listed in the US. It invests in large-cap blendstocks (both growth and equities). The Vanguard Total Stock Market ETF (VTI) invests across market caps in the US. On the other hand, the iShares Core S&P Mid-Cap ETF (IJH) and the iShares Russell 2000 ETF (IWM) are focused on mid and small-cap stocks, respectively.

There are ETFs that track specific sectors of the US equities market, like the Technology Select Sector SPDR Fund (XLK) and the Financial Select Sector SPDR Fund (XLF).

ETFs like the Vanguard FTSE All-World ex-US ETF (VEU) provide exposure to stocks beyond US shores, while those like the Vanguard FTSE Developed Markets ETF (VEA) and the Vanguard FTSE Emerging Markets ETF (VWO) provide exposure to the analytical groups of developed and emerging markets respectively.

Then some ETFs provide exposure to US bonds (iShares Core U.S. Aggregate Bond ETF (AGG)), emerging market bonds (PowerShares Emerging Markets Sovereign Debt (PCY)), commodities (PowerShares DB Commodity Index Tracking Fund (DBC)), and currencies (PowerShares DB US Dollar Bullish Fund (UUP)).

The more exotic variety of index-tracking ETFs are leveraged and inverse ETFs. There are target retirement date ETFs available as well.

Given their structure and basic philosophy of providing access to an asset class as investment pools, Exchange Traded Funds are often compared to mutual funds. Though there are similarities, ETFs differ from their mutual fund peers in some important aspects. Let’s take a look at these differences.

Exchange-Traded Funds vs. Mutual Funds

Both Exchange Traded Funds, and Mutual Funds are baskets of securities that issue shares or units to investors in exchange for providing indirect access to that basket. The shares or units of both investment vehicles can be created and redeemed on demand without there being a cap on the number of outstanding shares or units. However, there are some important differences.

Active Management

While most ETFs mimic an index and thus are passively managed products, a large section of mutual funds are actively managed, i.e., there is an investment manager who decides the composition of the underlying basket of securities based on his view on specific stocks.

Cost of Investing

Due to their passive nature, most ETFs are cheaper than their actively managed counterparts. Even if we compare index mutual funds, which are themselves passively managed, to ETFs, the latter may be a bit cheaper than the former. One needs to be cognizant of the trading costs associated with ETFs, though, which can reduce their advantage over relatively cheaper mutual funds.

Tax Friendliness

ETFs can also be more tax-efficient than mutual funds. This is primarily because they tend to have lower portfolio turnover than actively managed mutual funds, resulting in comparatively lower capital gains. They are also more transparent than mutual funds as their composition is available on a daily basis. In contrast, mutual funds are available once a month, quarter, or even lower frequency.

Trade-ability

The most prominent difference between the two is their availability. While mutual funds can be traded once a day after the end of trading, ETFs can be traded throughout the day on the exchange like individual stocks. One needs a brokerage account to do so, and the process is the same as buying or selling a stock. Though ETFs can be purchased from the fund provider, it needs to be done in large blocks of creation units, which is out of reach of retail investors. On the other hand, to buy or sell a mutual fund, an investor necessarily needs to approach the fund house. Though some open-end mutual funds are listed on exchanges, they have very little trading volume, if at all, thus making approaching the fund house for trade almost compulsory.

Read more about other types of Derivative Instruments.