For those versed with the mutual fund industry, exchange traded funds could fit the bill of “disruptors” or “game changers”. Exchange traded funds or “ETFs” for short are securities traded on different markets all over the world. They track an underlying asset which you will learn about later.
The first mutual funds came forth in 1973 from Wells Fargo, and American National Bank. These followed papers written onf the concepts of diversification and passive investing. During the bull market of 1990s investors made handsome returns by investing in portfolios benchmarked to broad-based market indexes such as the S&P 500, Russell 3000 and Wilshire 5000. Notice that diversification and passive investing are two key points of ETFs, similarly to mutual funds, but let us explain the difference between the two below.
Recently, fees charged by mutual funds have caused a lot of resentment among investors. Most index funds have continued to outperform actively managed funds today which has added some fuel to the fire. These factors led to a demand for instruments similar to mutual funds, but at a lower management cost. Exchange traded funds filled this market need and growth has been unprecedented during the past few years, with the number of ETFs going from 276 in 2003 to 4,779 in 2016.
So How Do Exchange Traded Funds Work?
To understand the ETFs creation process we first need to comprehend how mutual funds are created.
Interested investors provide the mutual fund with cash. The fund manager then uses this cash to buy securities which are balanced out by issuing additional shares of the fund. At the time of redemption, investors return these shares to the fund and receive cash, equivalent to the market value of shares.
Greenhorn investors usually believe that exchange-traded funds are born in a similar fashion, however, it is not the case. The ETF creation cycle starts when a prospective ETF manager, or sponsor, files a plan with the US Securities and Exchange Commission (SEC).
Following the filing, the SEC goes through the plan with a fine-tooth comb and approves it if everything is in order. The ETF manager then creates a partnership with an authorized participant being a specialist, market maker, or large institutional investor. These essentially being entities that buy large amounts of shares in the open market. In a few cases the AP and sponsor are one in the same.
The authorized participant then borrows shares from an entity such as a pension fund and positions those shares in a trust to form ETF creation units. Thereafter the trust provides shares of the ETF to the authorized participant. As the final step, the ETF shares are sold by the AP to the public.
On the other side of the spectrum is the redemption process. At the behest of the investor, the brokerage firm accepts a sell order which is then received by the market maker. The market maker in turn hands the ETF to the AP who dis-assembles the ETF and returns the shares to the market.
Types of Exchange Traded Funds
As mentioned in the first section exchange traded funds track underlying assets that could include a variety of securities such as Norwegian equities, Japanese tech stocks, Chinese real estate stocks, spot gold bullion, oil, wheat etc. Recently there were attempts to create an ETF for Bitcoin, these attempts were stonewalled by regulators due to issues of risk and security associated with cryptocurrencies. Thus, the first step to navigate this market filled with an untold number of options is to understand the broad categories.
Index ETFs are the cornerstone of the exchange traded funds market. An S&P 500 proxy was the first to be traded on the American Stock Exchange and the Philadelphia Stock Exchange. Its existence was short lived as a lawsuit by the Chicago Mercantile Exchange was successful in halting sales. One year later the Toronto Index Participation Shares started trading on the Toronto Stock Exchange and became popular among investors.
As you may have gathered by now, Index ETFs are proxies for specific indexes that can be based on stocks, bonds, commodities, or currencies. Within index ETFs there are two major categories – replicated, and relative sampling. Replicated ETFs invest 100% of their assets based on the allocation of the underlying index. Whereas, representative sampling ETFs invest 80% to 95% of their assets based on the underlying index, and the remaining 5% to 20% in instruments such as futures, options, and swap contracts.
Market Sector ETFs
Market sector ETFs track sectors such as healthcare, finance, technology and foreign markets. They can be an excellent way to gain market exposure if the investor is interested in a sector as compared to owning an individual stock. However, critics have argued since the inception of mutual funds that market funds are not necessary. According to them it’s just a way for people to be investing fashionistas i.e. investing in the latest fads.
Market Cap ETFs
Close cousins of market sector ETFs and equally begrudged by critics. Market Cap ETFs track indexes that invest based on market capitalization. For instance, the S&P 500 index is a large cap index that tracks the largest stocks in the US. The Russell 2000 index mostly tracks small-cap stocks. Small caps are unique as they are more sensitive to market changes and in many cases going bankrupt during times of recession. Investors are encouraged to exercise caution and conduct their due diligence before taking positions in the small-cap market.
Bond ETFs, track funds that invest in bonds. Unlike small-cap stocks, bonds move in the opposite direction of the economy because investors move out of stocks and invest in more stable instruments such as government bonds during times of recession. Notably, the performance of small-cap stocks and bonds are leading indicators of changes in economic conditions.
Simply put, Commodity ETFs track commodities, and do not track a fund. Commodity ETFs are similar to stock ETFs as in they track individual commodity prices. A word of caution. Commodities are a completely different beast as compared to stocks. Woe to those who do not understand this, as they will likely make decisions based on asinine assumptions, leading to huge loses.
For instance, decisions made by the OPEC, which in turn affects the demand and supply of oil, can have profound implications on the price of oil. Furthermore, the way investors gain exposure to the underlying commodities is very different, with the notion of roll costs coming into play. Front-month contracts are used, causing the investor to be subject to different prices along the term structure.
Currency ETFS, like commodity ETFs, track an underlying currency instead of a fund. There is a wide array of currency ETFs available in the market and the first ETF called the Euro Currency Trust, was launched in 2005. Again, just like commodity ETFs, currency ETFs have their own unique determinants of price.
Actively Managed ETFs
According to many experts actively managed ETFs are the anti-thesis to the original pillars upon which ETFs were built. Essentially they track actively managed funds. Higher fees, hidden costs, and other myriad problems associated with actively managed funds do seep into actively managed ETFs. According to certain estimates, costs that come with actively managed funds can reduce returns by up to 2.66% – a mammoth decrease given the average long term return for American equities has been 6.45% per annum.
An inverse ETF is an advantageous vehicle in the investing arsenal. These ETFs perform the opposite of the underlying asset or fund. They provide the good of short-selling and leave out the bad. They are not subject to short-selling fees, and they protect investors from unlimited losses which is not the case with traditional short-selling. To put it in another way, investors will only lose on the purchase price of the inverse ETF. Inverse ETFs can also be held in IRA and CRA accounts which is not possible with traditional short-selling.
Leveraged ETFs aim to achieve results that are more sensitive to market movements. They come in two varieties, either bull, or bear. A leveraged bull ETF will achieve a positive multiple of the market return, whereas the leveraged bear ETF will aim for a negative multiple return.
Leveraged ETFs are a perfect example of a double-edged sword. They have the potential to generate lots of money. But if the underlying index is volatile the rebalancing requirements to maintain the fund’s objective will be huge, leading to increased costs which in turn requires higher returns to remain positive.
Exchange-Traded Grantor Trusts
Exchange-traded grantor trusts resemble ETFs due to characteristics such as low costs, low turnover, and tax efficiency. These vehicles allow investors to access to a basket of investment vehicles including stocks or commodities. Grants turn investors into shareholders, giving them rights to dividends and voting power. Unlike an ETF which alters based on changes in the underlying portfolio, the basket of these trusts cannot be changed.
Exchange Traded Notes
ETNs provide the holder with returns based on underlying senior, unsecured, unsubordinated debt issued by an underwriting bank. They have a maturity date, are dependent on the creditworthiness of the issuer, and are usually traded on the stock market just like ETFs. But there is strong fundamental difference – an ETN does not have exposure to equities, equity-based securities, index funds or futures. In other words, they do not own any underlying assets.
Why Are Exchange Traded Funds So Popular Right Now?
As mentioned in the opening section, the number of exchange traded funds went from 276 in 2003 to 4,779 in 2016, which is a 17 times increase. What are the reasons behind the ubiquity of ETFs?
Low fees and costs are the main reasons behind the rise of ETFs. ETFs are passively managed, not subject to the high load fees normally associated with traditional mutual funds. ETF investors pay brokerage fees associated with buying and selling of shares, usually a fixed amount. Furthermore, ETFs do not incur 12b-1 fees (known as trailer fees in Canada), charged to cover the marketing and sales expenses associated with mutual funds. Finally, passive management also means lower rebalancing needs, leading to lower trading costs.
Icing on the cake, leading to even lower overall “cost” the for the investor. In general ETFs create fewer taxable events in contrast to most mutual funds. The reason – ETFs sell holdings only when the underlying index changes, which seldom happens. The rebalancing act in investment terminology, is referred to as turnover rate. In some cases, mutual funds have a turnover rate of 100%, whereas the average for ETFs is 10%.
Moreover, the capital gains of ETFs are similar to those of the stock investor. Mutual funds on the other hand are a lot more complicated. If a mutual funds gains, these gains must be distributed to shareholders. Such a situation can arise whenever a mutual fund sells portfolio securities. Whether it be to reallocate it’s investments or to fund shareholder redemption, once again, more taxable events mean more taxes.
ETFs, like stocks, can be traded at the whims of the investor. When an investor places a sell order for mutual funds they must wait until the end of day. At which point the Net-Asset-Value (NAV) of the fund will be calculated, and then the funds will be released. Following that, conversion to cash is not immediate. Worst case scenario, investors may have to wait up to 7 days to get their cash back.
Market exposure and diversification
ETFs are a great vehicle to gain market exposure without investing a considerable amount of money. With one share, an investor can be exposed to the entire US stock market. One can create a mish-mash of various markets, sectors, and assets according to their risk tolerance and goals.
Unlike many mutual funds, ETFs disclose the underlying portfolio and thus, allow investors to know exactly what they are holding.
The Cons Of Buying Exchange Traded Funds
It’s not all sunshine and roses in the ETF world. These instruments do have certain drawbacks, and prospective investors are encouraged to take these into consideration before buying.
The concept of arbitrage is the core of ETF weakness. Because ETFs track an underlying asset rather than invest in them, the price of the security can be different from the underlying NAV.
For instance, ETF X could experience a sudden increase in demand which could cause its market price to increase. However, the NAV of the underlying index has not changed. More often than not the AP will notice this mis-pricing. They will sell the ETF shares received during creation to make a profit between the cost of the assets bought from the ETF issuer and the selling price of ETF shares. Such a process will lead to an increase in supply of ETF X and elimination of the price gap between the NAV and ETF’s market value.
Pricing deviations are more pronounced for certain exchange traded funds as compared to others. For instance, ETFs that are exotic, newer, or thinly traded are more vulnerable to being mis-priced than regularly traded, popular ETFs. Overpriced ETFs will revert to their original values once the AP steps in. If you buy the ETF when it is trading at a premium you will lose your capital when this price correction occurs. On the flip-side, it can be profitable to buy exchange traded funds that are trading at a discount.
Replicating An Index Is Hard
Even though ETFs are advertised as clones for funds, fully replicating an index is a cumbersome and difficult task. The reason being that many index funds have thousands of constituent securities, with some being less liquid than others. As a result, managers make judgment calls – should they include a stock that would have minimal effect on the performance of the index but is costly to acquire due to its illiquidity?
In other words, they try to optimize an ETF and use a “sample” set of securities in a fund, rather than the entire fund. As a result, an ETF does not provide the exact same returns as the underlying index. The difference between the two returns in known as tracking difference. And the volatility of this tracking difference is represented by the tracking error.
In some cases, stocks in the index incur dividends, which in turn have to be distributed to shareholders. However, in case of ETFs this does not happen immediately. The time between receiving the dividend and when it is distributed is known as a cash drag. Thus, something must be done with this cash, such as reinvestment or holding. Either of these tasks have costs, adding to the tracking difference. Thus, tracking difference and error are the most important metrics to take into consideration before investing in an ETF. In general, you want to look for ETFs that are low on both counts.
Fad ETFs May Be A Hard Sell
New kids on the block or fad ETFs may seem like they are upping the ante by being more sophisticated, but the reverse is usually true. Often new ETFs do not have many suitors because they are thinly traded and therefore, difficult for the investor to sell. Such a situation would lead to a high bid-ask spread, leading to decreased returns. Moreover, some new ETFs can be overwhelming and too complicated for the average investor. What may seem like a great investment could be just smoke and mirrors.
So Are Exchange Traded Funds Right For Me?
There are many dialects of wealth management, ETFs being one of them. Whether you need to understand the ETF language depends on your needs. If you are a novice investor and possibly lack knowledge about investing and trading individual stocks, then there may be a need for a safe and simple investment strategy provided by ETFs.
Other cases when ETFs are suitable could be when you want to gain industry exposure, not worry about stock picking and portfolio balancing or don’t want to listen to the twaddle of personal advisors.
What Makes A Good ETF?
Outlined in the cons section, ETFs can have certain major flaws and not all ETFs are created equal. Buying the wrong ETF can have a negative effect on your emotional state and bank balance. How does one sift through the wide array of ETFs available on the market? How can one cleanly and clearly separate the good from the bad?
One general rule, go for originals instead of imitations. This is the best way to separate the wheat from the chaff. Older exchange traded funds have higher liquidity, more stability and low tracking errors.
Below are some of the best and most stable exchange traded funds
Vanguard FTSE Emerging Markets ETF
Tracks the performance of FTSE Emerging Index, which entails approximately 850 large and mid-cap companies in 22 emerging markets. It was launched in 2005 and has $72 billion of AUM and an expense ratio of 0.14% as of 2017. More info here.
SPDR S&P 500 ETF
Launched in 1993, the SDPR S&P 500 ETF tracks the S&P 500 – probably the most popular stock market index in the world. It has an expense ratio of 0.09% and market cap of $237 billion as of 2017. More info here.
SPDR Gold Shares
A commodity ETF that tracks the price of gold bullion, and hence moves up or down with the price of gold. This ETF is physically backed by gold held in HSBC’s vault in London. With a market cap of $35 billion, it is the largest gold ETF in the world. More info here.
iShares Russell 2000
Another stock index based fund, this one focused on small-cap companies. Expense ratio of 0.20% with $40 billion AUM. More info here.
Power shares DB Commodity Index Tracking Fund
A good option for those looking to gain commodities exposure. It tracks the DBIQ Optimum Yield Diversified Commodity Index, made up of future contracts on 14 of the most liquid physical commodities in the world. Covering energy, agriculture, and metals the fund had assets of over $2 billion in 2017. An average daily volume of over 1.4 million shares with an expense ratio of 0.89%. More info here.
How to buy an ETF
The process of buying an ETF is identical to that of buying a stock. You first need to have a brokerage account. If you want more information on the best brokerage accounts, you can view our review of top brokers in the US and Canada. Following that, the mechanisms that are used in stock trading such as stop losses, short selling and limit orders can also be used for ETFs. You can buy an ETF whenever you want and sell it whenever you want, provided that the stock market is open. It is just that simple!