Understanding the structure and characteristics of Exchange Traded Funds is essential to effectively evaluating the potential benefits and pitfalls of this investment vehicle

First, the basics. An Exchange Traded Fund owns a basket of securities, like a mutual fund, but the shares of the fund are a tradeable security. Retail investors buy and sell the shares on the open market. In fact, the ETF is specifically structured so that retail investors can only buy and sell ETF shares in the market. This creates characteristics that make the funds appealing to investors:

  • the flexibility and liquidity of a traded security – so investors can buy and sell at any time, use limit/stop loss orders, hedge their investments
  • potentially greater tax efficiency – because retail investors are not buying & redeeming shares, there is lower turnover, reducing capital gains and losses passed on to shareholders
  • potentially lower costs – fewer transactions for the fund
  • easy diversification – as with a mutual fund
  • transparency – the composition of the fund is posted daily

Creating those characteristics entails a secondary structure that is largely invisible to the retail investor. But that structure has implications that the investors in ETFs must consider.

An investment firm creates the legal entity for the fund, then assigns or hires an investment advisor to run it. The fund is actually created by selling “creation units” to selected other institutional investors, who generally pay for these rights by providing shares of the underlying equities comprising the fund.

Those institutional investors become the ongoing customers of the fund. They can buy additional blocks of shares (as “creation units”) from the fund by again exchanging shares of the stocks comprising the ETF. Similarly, they can redeem shares in the fund for shares of the underlying stocks. These institutional investors can then sell those shares to retail investors as well as buy and sell them on an exchange.

The creation and redemption of shares is done only in very large blocks and only by the eligible institutional investors. It is therefore much less frequent than the sale and redemption of shares in a mutual fund. Creation and redemption is also executed largely in shares of the underlying equities. So the manager of the fund needs much less cash on hand than a typical mutual fund. Less cash means less assets earning a return different from the fund’s target. The manager also buys and sells the securities much less frequently, reducing the capital gains and losses that have to be distributed to the investors. These structural characteristics drive the potential benefits of lower costs and better tax efficiency outlined above.

The institutional investors also provide an essential arbitrage function to ensure that the price of the ETF shares as traded in the market does not deviate far from the net asset value of the underlying stocks. A closed-end fund, which an ETF resembles, can indeed trade at significant variance from its underlying investments. But significant volatility and variance from NAV would undermine a core argument for investing in ETFs instead of traditional mutual funds.

This arbitrage is made possible by the required that Exchange Traded Funds provide complete and constant (daily) transparency on their positions to all investors. The large institutional investors who have the ability to create more shares (or redeem shares) watch these prices carefully. Because they are active in the market, and are presumed to have the financial capital and liquidity to act.

  • If the price of the ETF is significantly above that of the underlying equities, they earn an arbitrage profit by selling shares into the market and receiving more for them than the cost of the equities they give up to create the shares.
  • Conversely, if the price of the ETF is significantly below that of the underlying equities, they earn the arbitrage profit by buying shares in the market, redeeming them and receiving more a higher value in the underlying stock they receive in return for the shares.

The track record of this arbitrage in maintaining prices close to net asset values is generally good, but is the subject of ongoing analysis and study. Markets can lock up and fail; institutional investors can be unable or unwilling to execute the necessary artibrage. It could be harder to perform the arbitrage successfully given the wide range of stocks that could be required to perform the arbitrage.

The interlinked structure of an Exchange Traded Fund gives rise to concerns about conflict of interest among the fund manager, fund advisors and the institutional investors who are the funds customers. Those institutional investors likely have other relationships with the fund manager which could be a source of conflict. Particularly challenging in this regard are brokerage relationships.

These interrelationships, combined with the full and daily disclosure of positions in an ETF required for maintaining the price/NAV relationship, opens the possibility of other risks to investors in the fund:

  • A firm with knowledge of the transactions to be made in managing the fund (buying and selling stocks) could front-run by trading ahead of the fund and making a profit.
  • Free riders, seeing what the fund is doing, could potentially trade in and out of the holdings, making a profit and potentially moving prices, without being invested in the fund.

There is continuing debate, research and analysis of these structural risks. Investors and advisors should keep abreast of developments.

The potential risks are magnified in the case of actively-managed funds, where the potential for asymmetric information (some investors have much more information than others) is greater.

These potential risks are of great concern to the SEC, one of the reason for the waiver process required to offer an actively-managed ETF.

Some Statistics on Ecxhange Traded Funds

The total assets held in Exchange Traded Funds (ETFs) are still a small fraction (10%) of those held in mutual funds – $777 billion at the end of 2009 compared to $7,805 billion ($7.8 trillion) in equity and bond mutual funds. (The total value held in mutual funds, including money market funds, is larger still, at $11,121 billion.)

There is even more disparity between passive and actively-managed funds. At the end of 2009, there were only 21 actively-managed ETFs amoung the 797 funds in existence. Those funds only managed about $1 billion (0.13%) of the $777 billion in ETF assets.

ETFs have grown rapidly. Since 2002, when the assets held in ETFs reached $100 billion, they have grown at a compounded rate of 33% yearly. The growth in assets was matched by the increase in the number of different funds, from 113 at the end of 2002 to 797 at the end of 2009.

ETFs are overwhelmingly invested in equities – 77% of total assets held. The breakdown by asset class is:

  • Broad-based domestic equities – 39%
  • Sector-focused domestic equities – 11%
  • Global/international equities – 27%
  • Bonds – 14%
  • Commodities – 1%
An overview of Exchange Traded Funds

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