ETF Terms You Should Know
There are a lot of terms the ETF industry uses every day, some of them unique to the ETF structure. Here’s a list of some of the most commonly used terms in ETF land, ordered alphabetically from letter C to letter D.
- A - B
- E - M
- N - U
Contango/Backwardation: These are terms seen across the commodity ETF space. They pertain to roll costs associated with moving from one futures contract to another. When an expiring futures contract is cheaper than—or trading at a discount to—the next month’s contract, the futures curve is in contango. Contango translates into roll costs to an investor (or an ETF) having to move from one contract to the next. The opposite of contango is backwardation, when the expiring futures contract is trading at a premium to the next contract. Contango and backwardation impact commodity futures and futures-based ETF returns. Many commodity ETFs try to optimize their roll strategy to circumvent the impact of contango on returns.
Closed-End Funds: These are baskets of securities that come to market with a fixed number of shares. They trade intraday, so they often trade at premiums or discounts to their net asset value due to their inelastic supply of shares. They often pay out dividends and capital gains distributions.
Counterparty Risk: It’s the risk an investor faces that whoever is on the other side of the deal might fail. For example, ETF issuers offer a pattern of returns for a given fee in an ETF wrapper. They can be a source of counterparty risk if they don’t deliver on what that ETF prospectus promises. Depending on the type of exchange-traded product, counterparty risk is higher or lower. Exchange-traded notes, which are debt instruments, pose counterparty risk associated with the institutions backing them and whether they can meet these debt obligations. ETFs that use a lot of derivatives contracts in their portfolios can also face counterparty risk stemming from the parties issuing these contracts.
Creation/Redemption Mechanism: It’s how ETF shares are created and redeemed, in a process that’s unique to the ETF structure. (We have a diagram detailing this mechanism here.) When there’s demand for new shares of an ETF, an authorized participant buys the securities the ETF holds, and hands that basket of securities to the ETF issuer in exchange for ETF shares. This is known as an in-kind transaction—securities for shares. In the case of a redemption, this process works in reverse. The in-kind nature of the creation/redemption mechanism is crucial to how ETFs trade because it allows them to trade throughout the day in line with the value of their underlying holdings (their net asset value).
Custodian: In the ETF ecosystem, the custodian—often a large bank—is responsible for holding all the securities and cash for an ETF. That custody role is crucial to the day-to-day operations of a fund, even if it’s a largely overlooked role by most investors. Custodians hardly make headlines, and most investors don’t know who custodies the ETFs they own. But occasionally custodians are all the buzz, when companies involved with things like federally illegal marijuana find their way into ETF wrappers. Then suddenly, custody becomes a hot-button issue.
Custom Basket: Like it sounds, a custom basket refers to a select grouping of securities, customized for a purpose. In ETFs, custom baskets come into play during the creation/redemption process for the purpose of improving tax efficiency. When ETF issuers rebalance portfolios, some ETF holdings may have incurred capital gains, which would have to be realized at rebalance. A custom basket is an in-kind mix of only certain securities the ETF issuer wants to trade (redeem) to avoid having to pass on capital gains distributions down the road. Until recently, only some ETFs were allowed to use custom baskets, but the Securities and Exchange Commission changed that when, in September 2019, it approved Rule 6c-11, known as the "ETF Rule." Under the new rule, effective in 2020, all ETFs may use custom baskets, which is great news for ETF investors everywhere.
Direct Indexing: Direct indexing is index investing without any wrapper around it. Some say it’s going to be the next big thing, and potentially disrupt the ETF space. In practice, direct indexing means buying all the stocks found in the S&P 500 instead of buying a single ticker in the form of an S&P 500 ETF. In that process, you, the investor, can custom-create your own index by picking and choosing the securities you want to own—no middleman, or better yet, no middle ticker.