Actively Managed ETF
Most ETFs track an index, in what’s known as index-based or passive investing. An actively managed ETF is a fund that literally has a portfolio manager at the helm of the fund, making active allocation decisions rather than passively tracking a benchmark. Active managers have long been plagued with persistence issues—meaning that few outperform indexes, and the ones that do aren’t likely to repeat that outperformance consistently—hindering adoption of actively managed ETFs, which are often more expensive to own than their passive counterparts.
Alpha is return that can’t be simply explained by market movement. In the ETF space, alpha is primarily the “extra juice” an active manager can extract beyond the market performance, as measured by an index. But it can also be outsized gains achieved through index-based ETFs that track some form of smart beta benchmark designed to deliver outperformance relative to a segment of the market.
He or she is the protagonist of the ETF creation/redemption process most investors will never know. Designated by an ETF issuer, the AP is someone with purchasing power who creates and redeems shares of an ETF, keeping the supply elastic to meet demand. When there’s new appetite for a given ETF, the AP will create shares of that ETF through the in-kind creation/redemption mechanism, keeping supply ample and helping the ETF trade in line with its net asset value (NAV). Ample supply means no need for steep premiums. When demand dries up and ETF share prices face a discount, the AP can redeem shares of the ETF from the market, reducing supply, allowing the ETF to trade back in line with its NAV. The AP plays a crucial role in ETF liquidity and trading.
Beta is the correlation between a stock and the broader market, or the performance of an ETF relative to the segment of the market it accesses. The higher the beta, the more sensitive a stock or an ETF is to market moves. (We list “beta” for most ETFs in our fund pages—etf.com/ticker—under the tab “Fit.”)
ETFs trade like single stocks, so bid/ask spreads are a part of daily life for an ETF. The spread is simply the difference between the price someone is willing to pay for an ETF (the bid) and the price someone is willing to sell that ETF for (the ask). The most important takeaway here is that the wider the spread, the more expensive it is to trade that ETF. That’s why we list the “average spread” for all ETFs on our fund pages (etf.com/ticker) along with other crucial data points such as expense ratio, assets under management and average daily volume. This metric should be part of your ETF due diligence if costs are important to you.
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.
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.
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.
It’s how ETF shares are created and redeemed, in a process that’s unique to the ETF structure. 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).
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.
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 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.
ESG is a set of metrics outside traditional fundamentals that can explain or impact a company’s bottom line over time. When it comes to assessing the investment case of a company, ESG speaks to its business’ sustainability, environmental footprint, social impact, management and diversity efforts as well as ethical issues. ESG ETFs incorporate ESG metrics in their security selection and weighting in an effort to offer more targeted access for investors looking to be socially responsible, or environment friendly with—or to impact-invest—their money.
An ETF is essentially an investment wrapper, merely a vehicle. It’s a basket of securities that offers diversified access to an area of the market. An ETF can invest in everything from stocks, to bonds, commodities, currencies, as well as derivatives, or a mix of any of these different assets. An equity ETF, for example, is a portfolio of several stocks from different companies; a Treasury ETF is a portfolio of several bonds, and so on. ETFs are structured much like a mutual fund except that they list and trade on a stock exchange under a single ticker, like a single stock.
An ETN is a debt note issued by a bank. ETNs can access just about every corner of the market, and can often package complicated strategies, but they introduce counterparty risk associated with the issuing bank.
The expense ratio is the operating expenses an ETF incurs over a given year divided by its assets. While the expense ratio is not the total cost of ownership an ETF investor faces, it’s the most commonly used metric to assess the cost of an ETF.
One of the most commonly used structures for commodity ETFs, a grantor trust is a physically backed trust that stores the physical commodity—say, gold bars or silver coins—in vaults while giving investors exposure to spot returns of that commodity. The biggest example of a grantor trust is the SPDR Gold Trust (GLD). By owning shares of GLD, ETF investors actually have claim to physical gold being vaulted in London.
These are exchange-traded funds that are designed to mimic the performance of an underlying index, delivering the same returns minus fees. Index-based ETFs simply replicate a benchmark either by owning every security included in that index, or by using a representative sample of securities. Most of the 2,200-plus ETFs on the market today are index-based, or passive ETFs.
Leveraged ETFs offer enhanced returns of a given index over a short period of time. For example, a 2x S&P 500 ETF is designed to deliver twice the daily return of the S&P 500 index. Most often, the amount of leverage is reset daily, making these vehicles ideal for daily or very-short-term holding periods due to the compounding nature of their returns. They are not long-term, buy-and-hold instruments, but tactical tools for short time horizons. Inverse ETFs work similarly, but they offer the inverse performance of an index.
Also known as a liquidity provider, a market maker is someone who facilitates ETF trading, ensuring tight bid/ask spreads, depth and smooth trading throughout the day. Every ETF has a lead market maker, many of which are incentivized by exchanges to keep markets humming along.
Net Asset Value
The net asset value (NAV) is a measure of the fair value of an ETF share. It’s the sum of the value of all the securities in an ETF basket, divided by the number of shares of each security in the portfolio. In other words, the NAV tells you how much a share of an ETF is actually worth.
Nontransparent Active ETFs
ETFs are known for their transparency, with portfolio holdings that are disclosed in real time every day. Nontransparent active ETFs seek to keep the secret sauce of many portfolio managers secret by disclosing portfolio holdings only periodically. These proposed ETFs work either by introducing a “trusted agent” in the process who would create/redeem shares through confidential accounts for the APs, or by using proxy portfolios that don’t represent the entire basket in an effort to keep holdings secret. It has long been said that transparency has kept many active fund managers away from the ETF market, so the argument goes that a nontransparent wrapper could revolutionize the space.
These are portfolios of securities that have an elastic supply of shares that trade on an exchange at net asset value. ETFs and most mutual funds are open-end funds.
This is the common practice of ETFs lending underlying securities to short-sellers. By lending out securities, the ETF picks up extra revenue that can ultimately lower overall costs and boost results for the ETF. If an ETF holds a hot in-demand security, lending it out can generate significant revenue for ETF shareholders. The biggest risk associated with this practice is counterparty risk.
Smart Beta ETFs
One of the most controversial commonly used terms in the ETF market is “smart beta,” but its adoption is widespread. Smart beta ETFs are funds that forgo traditional market capitalization weighting for some alternative scheme, be it equal-weighting portfolio holdings, or some form of factor-based weighting, or dividend- and revenue-weighting methodologies, to name a few. About half of all U.S.-listed ETFs are some flavor of smart beta.
Tracking Difference/Tracking Error
Most ETFs are designed to track an index. Tracking difference, simply put, is the disparity between the returns of an ETF and the performance of the underlying index it tracks. In a perfect world, an index-based ETF would deliver exactly the performance of the index minus its fees (the expense ratio). But other factors can contribute to tracking difference, such as trading and rebalancing costs, as well as tracking methodologies that differ from the original benchmark, among other things. Tracking difference is not to be confused with tracking error, which is a measure of how volatile the performance difference between an ETF and its index is—the standard deviation—on an annualized basis.
Unit Investment Trusts
One type of ETF structure, UITs blend traits of open-end and close-end mutual funds by offering a diversified basket of assets open to investors, but one that’s first issued through an initial public offering. UITs also come to market with a set number of shares and an expiration date. The SPDR S&P 500 ETF Trust (SPY) is the biggest example of a UIT, and one that has had its expiration date postponed over time.
(This is not an exhaustive list, of course. We’ll keep adding terms online, so check back often at the ETF.com Education Center or contact Cinthia Murphy at [email protected].)