6.3 Exchange-Traded Funds (ETFs)

ETFs combine features of mutual funds and individual stocks. They offer diversification like mutual funds but trade on exchanges throughout the day like stocks. ETFs have grown dramatically in popularity due to their low costs, tax efficiency, and trading flexibility.

ETF Characteristics

Trading Features

Trading: ETFs - Throughout the day on exchanges; Mutual Funds - Once daily at NAV

Pricing: ETFs - Market price (may differ from NAV); Mutual Funds - NAV only

Order Types: ETFs - Market, limit, stop, stop-limit; Mutual Funds - Market order only

Short Selling: ETFs - Allowed; Mutual Funds - Not allowed

Margin Trading: ETFs - Allowed; Mutual Funds - Not allowed

Minimum Investment: ETFs - Price of 1 share; Mutual Funds - May have minimums ($1,000+)

Structure

Most ETFs are registered as either:

- Open-end management companies (most common)

- Unit investment trusts (older ETFs like SPDR S&P 500)

ETFs hold a basket of securities (stocks, bonds, commodities) and issue shares representing ownership in that basket.

The Creation/Redemption Mechanism

ETFs use a unique process involving Authorized Participants (APs) that keeps prices close to NAV and provides tax efficiency.

How It Works

Creation Process:

1. AP assembles basket of underlying securities

2. AP delivers securities to ETF sponsor

3. ETF sponsor issues new ETF shares to AP

4. AP sells ETF shares on exchange

Redemption Process:

1. AP purchases ETF shares on exchange

2. AP delivers ETF shares to ETF sponsor

3. ETF sponsor delivers underlying securities to AP

4. AP sells securities in the market

Authorized Participants

Who They Are: Large institutional investors (banks, broker-dealers)

Role: Create and redeem ETF shares with fund sponsor

Arbitrage: Keep ETF price close to NAV through creation/redemption

Limited Number: Only registered APs can transact directly with the fund

In Practice

If an ETF trades at a premium to NAV, APs can profit by:

1. Creating new ETF shares (deliver cheap basket, receive expensive ETF shares)

2. Selling ETF shares on exchange

3. This creation increases supply and pushes ETF price down toward NAV

ETF Tax Efficiency

ETFs are generally more tax-efficient than mutual funds due to the in-kind creation/redemption process.

Why ETFs Are Tax-Efficient

In-Kind Redemptions: Securities transferred out, not sold - no taxable event

No Forced Selling: When investors sell ETF shares, fund doesn't sell holdings

Tax Lot Management: Can transfer out highest-cost-basis shares

Lower Turnover: Most ETFs passively track indexes

Mutual Fund Tax Disadvantage

When mutual fund investors redeem shares:

1. Fund must sell securities to raise cash

2. Selling triggers capital gains

3. ALL shareholders receive taxable distribution

4. Even investors who didn't redeem owe taxes

On the Exam: The key to ETF tax efficiency is the in-kind creation/redemption process. When an AP redeems ETF shares, they receive the actual securities - not cash. Since no securities are sold, no capital gains are realized.

Types of ETFs

Index ETFs (Most Common)

Broad Market: What It Tracks - Total stock market. Examples: VTI, ITOT

Large-Cap: What It Tracks - S&P 500, large companies. Examples: SPY, IVV, VOO

Small-Cap: What It Tracks - Russell 2000, small companies. Examples: IWM, VB

International: What It Tracks - Foreign developed markets. Examples: EFA, VEA

Emerging Markets: What It Tracks - Developing economies. Examples: EEM, VWO

Bond: What It Tracks - Fixed-income indexes. Examples: AGG, BND

Sector and Industry ETFs

Focus on specific sectors with higher concentration risk:

- Technology (XLK, VGT)

- Healthcare (XLV, VHT)

- Financials (XLF, VFH)

- Energy (XLE, VDE)

Specialty ETFs

Inverse ETFs: Characteristics - Move opposite to index. Risks: Daily reset; not for long-term

Leveraged ETFs: Characteristics - 2x or 3x daily returns. Risks: Compounding decay; very high risk

Commodity ETFs: Characteristics - Track commodity prices. Risks: Contango, roll costs

Currency ETFs: Characteristics - Track foreign currency values. Risks: Currency fluctuation

Leveraged and Inverse ETFs

These products require special understanding due to their unique risks.

Daily Reset Problem

Leveraged and inverse ETFs reset daily, which causes compounding decay over longer holding periods.

Example: 2x Leveraged ETF Over 2 Days

Start: Index Return - ; 2x ETF Return - ; Index Value $100; 2x ETF Value $100

Day 1: Index Return +10%; 2x ETF Return +20%; Index Value $110; 2x ETF Value $120

Day 2: Index Return -9.09%; 2x ETF Return -18.18%; Index Value $100; 2x ETF Value $98.18

The index returned to $100 (0% total), but the 2x ETF lost $1.82 (-1.82%)!

Suitability Concerns

Suitable For: Short-term traders; Sophisticated investors; Hedging strategies; Day trading

NOT Suitable For: Long-term investors; Buy-and-hold strategies; Retirement accounts; Uninformed investors

On the Exam: Leveraged and inverse ETFs are designed for short-term trading only. Due to daily resetting and compounding effects, holding them long-term can result in significant deviation from expected returns.

ETFs vs. Mutual Funds: Complete Comparison

Trading: ETFs - Intraday; Mutual Funds - End of day

Pricing: ETFs - Market price; Mutual Funds - NAV

Expense Ratios: ETFs - Generally lower; Mutual Funds - Generally higher

Tax Efficiency: ETFs - More efficient; Mutual Funds - Less efficient

Minimum Investment: ETFs - 1 share; Mutual Funds - Often $1,000+

Sales Loads: ETFs - None; Mutual Funds - May have loads

Commissions: ETFs - May pay commission; Mutual Funds - None (direct purchase)

Automatic Investing: ETFs - Less convenient; Mutual Funds - Easy systematic investing

Dividend Reinvestment: ETFs - May pay commission; Mutual Funds - Usually automatic/free

Key Takeaways

- ETFs trade on exchanges throughout the day at market prices that may differ from NAV

- Authorized Participants create and redeem ETF shares, keeping prices close to NAV

- In-kind redemptions make ETFs more tax-efficient than mutual funds

- ETFs generally have lower expense ratios than actively managed mutual funds

- Leveraged and inverse ETFs reset daily and are NOT suitable for long-term holding

- ETFs can be sold short and bought on margin, unlike mutual funds