What is an ETF?
Offering low-cost access to virtually every corner of the market, ETFs allow investors big and small to build institutional-caliber portfolios with lower costs and better transparency than ever before.
But what exactly is an ETF? And how does it provide these benefits?
To understand how ETFs work, the best place to start is with something familiar, like a traditional mutual fund.
Imagine half a dozen investors, sitting at home, each trying to figure out the best way to invest in the stock market. They could each go out and buy a few stocks on their own, but few people have the time or resources to manage a portfolio of 50 or 100 stocks.
Instead, they decide to band together. They pool all of their money and hire a professional investment manager to invest it for them.
To keep track of who invested what, each investor receives “shares,” representing their stake in the total investment.
Because it’s your money, you want to know how much your investment is worth … every day. So every day, the mutual fund tallies up the value of everything it owns, and divides it by the number of shares that exist. Presto-whammo: You know exactly what each share is worth.
If you want to buy more shares, you know the amount of cash to send the mutual fund for each share. If you want to sell shares, you know exactly how much cash to expect in return.
It’s an elegant system, and mutual funds have existed for about a century. They currently provide exposure to stocks, bonds, commodities and other assets.
But What About ETFs?
Technically speaking, an ETF is a mutual fund too. It’s a pooled investment vehicle that offers diversified exposure to a particular area of the market. It can invest in stocks, bonds, commodities, currencies, options or a blend of assets. Investors buy shares, which represent a proportional interest in the pooled assets.
It’s a garden-variety mutual fund in every aspect … except one.
And that’s a big one, which is hinted at in its very name: exchange-traded funds.
You buy shares in an ETF directly from any brokerage account. Just like you buy shares in a stock, you can enter a buy order in your Schwab or Fidelity account and buy almost any ETF you want.
You can also do it whenever you want. Whereas orders to buy or sell a traditional mutual fund can be processed only once per day (after the close of trading), ETF trades can take place any time the market is open. You can buy shares in the morning and sell them in the afternoon. You can buy them at 10 a.m., sell them at 11 a.m. and buy them again after lunch if you want.
You can also perform all sorts of stocklike strategies with ETFs that you never could with mutual funds: selling short, placing stop-loss or limit orders, even buying on margin.
And that’s just the beginning: The fact that ETFs are “exchange-traded” creates a series of other benefits that, according to many market observers, make them a better overall choice than traditional mutual funds for many reasons: lower costs, better tax efficiency, and more. Of course, in other situations, they can be worse: commissions, trading spreads and other risks.
The first modern mutual fund was launched in 1924, while the first U.S.-listed ETF, the SPDR S&P 500 ETF (SPY), made its debut in 1993. Today, nearly 30 years later, the ETF industry in the U.S. includes roughly 2,800 products with assets hovering around $7 trillion. Meanwhile, the mutual fund industry has seen extended periods of outflows in recent years.
In sum, an ETF is a tool that allows investors to access different corners of the market—everything from U.K. equities to Chinese tech stocks to high-yield bonds, spot gold bullion and more—at low costs, from the comfort of a traditional brokerage account.
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What is an ETN?
Investors typically use the term “ETF” to mean a lot of things that aren’t technically “exchange-traded funds”: commodity pools, grantor trusts and debt securities.
We’re guilty of this too: After all, this is ETFR, but we cover all types of products. It’s the term of art, so we’ll roll with it.
The most important of these structures to understand is the exchange-traded note (ETN).
ETNs are debt notes issued by a bank. When you buy an ETN, the bank promises to pay you a certain pattern of return. If you buy an ETN linked to the price of gold, for instance, the value of that ETN will increase if the gold price goes up.
The beauty of the ETN structure is that it can be linked to anything. There are ETNs that track commodities, and ETNs that track hard-to-reach corners of the equity market. They sometimes combine stock or bond positions with options overlays, or use other sophisticated strategies that would be difficult to package into a traditional ETF. In the commodity space, the ETN also offers significant long-term tax advantages compared with most ETFs.
The downside of an ETN is that if the underlying bank goes bankrupt, you lose essentially all of your money. There were, for instance, a few ETNs backed by Lehman Brothers. While most investors in Lehman’s ETNs fled before the firm shut down in 2008, anyone who held to the bitter end probably still has a bad taste in their mouth.
The good news is that this credit risk in most situations is minor. Institutional investors can “redeem” (get their money back) from the underwriter of an ETN daily. While anything can happen, you usually see major bank defaults coming more than a day or two ahead.
The even-better news is credit risk is easily monitored. ETF.com’s data provider monitors and reports on the credit risk of every ETN daily. It does that by watching the cost of credit default swaps (CDS) on the underwriting banks each day. CDS are like insurance—investors buy them to protect themselves against a company’s default—so they are the best possible view of the likelihood a bank will go down.
How do you check? Just pull up the Efficiency Tab on any ETN (e.g., www.etf.com/AMJ) and check out the ETN Counterparty Risk measure. If it says “Low,” you’re OK. If it says “High,” run for the hills.
The current roster of ETNs trading in the U.S. includes 94 products, with a total of $11.5 billion in assets under management. The number of ETNs stood at more than 160 at the end of January 2020, not too long before a large number of ETNs closed during the COVID crash in March 2020.
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Advantages of ETFs
The ETF structure has a number of advantages relative to other investment vehicles that make them attractive to individual investors, financial advisors and institutions alike. These advantages include the following.
Asset Class Coverage
ETFs cover a wide range of asset classes, and offer access to just about any asset, theme and/or strategy. ETFs can invest in all sorts of securities, including stocks, bonds, commodities (physical or futures contracts), derivatives, alternatives and currencies. They can offer access to sectors, industry segments, countries, themes, outcomes and the like.
The go-anywhere nature of ETFs allows for the construction of well-diversified portfolios that may be laser-focused on a given part of the market or offer broad exposure to major asset classes.
ETFs can be bought and sold throughout the day when markets are open. ETFs can also be sold short; they can be purchased on margin; and they allow for the use of limit orders and stop orders. The ability to place stop-loss and sell stop-limit orders on ETFs is an often-overlooked feature that can be beneficial to investors.
A stop-loss order is simply an order placed with a broker to sell a security when it crosses below a specific price threshold. For example, if an ETF share is purchased for $25.00 and a 10% stop-loss order is immediately placed on the share, the broker will execute the sale of the share at the market price when the ETF trades at $22.50 or lower. Note that a stop-loss order doesn’t guarantee the trade will be executed at $22.50, only that the sell order will be triggered at that level. If the price of the security is deteriorating rapidly, the sale could actually be executed at a lower price.
A sell stop-limit order is similar, except that more precise control can be exercised over the sale price. If a stop is entered at $22.50 with a limit of $22.00, the sale will be triggered once the ETF trades at $22.50 or lower, but the trade will only be executed if the broker can sell at a price of $22.00 or better. This allows the investor to ensure they receive a specific price or better for the ETF if the sale order is triggered. It’s important to note that if the price of the ETF quickly fell below $22.00 before the sale could be executed, then the sell order would not be filled (versus a stop-loss order, where the order would be filled regardless of the price once the ETF hit $22.50 or lower).
ETF investors can use stop-loss and sell stop-limit orders to ensure they lock in profits and limit severe drawdowns in the event of a sharp market decline. That’s a unique advantage of ETFs. By contrast, mutual fund sales can only be executed based on the net asset value of the shares of the fund once a day, at market closure.
ETFs typically have much lower expense ratios than actively managed mutual funds, and are usually comparable to or less expensive than index mutual funds. These lower costs are generally a result of lower internal fund operating costs and a lack of load or redemption fees. Because of their structure, ETFs are generally insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions, as is the case in mutual funds. When investors transact in their ETFs, they typically do so directly with other investors in their brokerage accounts, unlike mutual fund investors, who have to transact through the mutual fund company, which incurs several processing costs along the way.
Since ETFs are typically passively managed products, they also don’t include the costs of paying for expensive fund managers. Even in the case of actively managed ETFs—those that don’t track an index but instead have a fund manager making portfolio decisions—these funds are typically more cost-competitive than active mutual funds for the reasons listed above. ETFs tend to have much cheaper costs related to customer service departments, sales distribution, and other infrastructure associated with supporting and marketing large actively managed mutual funds. ETFs do not charge 12b-1 fees like their mutual fund counterparts. All of these cost efficiencies of the ETF wrapper translate into cost savings for ETF investors relative to similar mutual fund structures.
ETFs are not tax-free, but are tax efficient relative to traditional mutual funds. Behind that efficiency is the hallmark of the ETF structure: the creation/redemption mechanism. This mechanism of creating and redeeming ETF shares, keeping the share supply elastic to meet supply and demand, generally does not trigger a capital gains event because the IRS treats exchanges of index components for shares of ETFs as nontaxable, in-kind exchanges.
Consequently, ETFs can routinely expunge low-cost-basis holdings in the course of routine redemption activity. This results in ETFs typically carrying relatively high-cost-basis shares. When an index is reconstituted or rebalanced and, thereby causes the ETF to buy and/or sell corresponding holdings in order to track that index, the prior expunging of low-cost-basis holdings helps to minimize the risk of realizing capital gains. This process ultimately means you typically don’t have the taxable capital gains distribution exposure that you have with traditional mutual funds.
Most ETFs are required to report their underlying holdings on a daily basis so investors always know exactly what they own. Portfolio transparency has been a hallmark of the ETF structure, and one that stands in contrast to mutual funds, which are only required to report their holdings on a quarterly basis, and often 30 days in arrears at that.
This transparency is linked to the ETF creation/redemption process itself, where ETF issuers disclose daily what securities are in a given ETF portfolio so that an authorized participant or market maker knows what holdings they need to create shares of that ETF. Transparency is also a byproduct of the predominantly passive nature of ETFs, as index providers disclose index composition on a regular basis.
That said, in 2020, a new genre of ETFs came to market introducing portfolio opacity as a feature. Known as semi- or nontransparent ETFs, these new actively managed funds do not disclose portfolio holdings on a daily basis, but vary disclosure periods depending on the ETF model used.
Nontransparent active ETFs are still a novel minority of funds in the market today. The vast majority of the more than 2,800 U.S.-listed ETFs are fully transparent vehicles.
One of the great attributes of ETFs is portfolio diversification. ETFs trade as single stocks under a single ticker, but they are baskets of multiple securities. For example, the Vanguard Total Stock Market ETF (VTI) trades all day like a single stock, but its portfolio comprises more than 3,400 individual companies. Similarly, the iShares Core U.S. Aggregate Bond ETF (AGG) is a single fund that represents nearly 10,000 different bonds in a single portfolio. ETFs can also offer diversified mixes of assets, combining equities, bonds, alternatives and derivatives within a single portfolio.
Disadvantages of ETFs
The ability to trade ETFs throughout the day is great, but it often doesn’t come for free. Investors don’t buy or sell ETFs directly from ETF providers or sponsors, but instead, purchase them in the secondary market via an exchange accessed through a brokerage firm. Accordingly, investors may be required to pay a brokerage fee each time they trade an ETF, similar to purchasing an individual stock. The more you trade, the more you pay.
Several brokerage firms have started offering some or all ETFs with zero transaction fees, which can be a cost factor depending on the size and frequency of transactions.
Beyond commission fees on trading, the bid/ask spread is another important cost consideration. This spread is the difference between the price being bid (what you pay) and the price being offered (what you sell it for) for shares of the ETF being traded on the exchange.
Bid/ask spreads tend to reflect the weighted average of bid and ask sides for each of the component holdings within the ETF. ETFs representing more thinly traded segments of the market can, consequently, be expected to exhibit wider bid/ask spreads. ETFs with relatively low trading volumes also generally have wider bid/ask spreads than ETFs that are more heavily traded.
One rule of thumb that applies here is that, typically, the wider the spread, the more it can cost you to trade an ETF.
ETFs are designed to trade as closely as possible to their net asset value throughout the day—the fair value of their underlying holdings. But sometimes, especially in fast-moving markets, premiums and/or discounts can develop, resulting in potential losses to investors. That’s not the case in mutual funds, which can only be bought and sold once a day, at the end of the trading day, and always at net asset value.
Tracking error is a performance metric that also relates to the cost of owning an ETF. This error represents the difference between the returns of the ETF and the performance of the index it’s supposed to track. Tracking error tends to be lower for heavily traded ETFs and ETFs that represent heavily traded securities. The four most common reasons tracking errors occur are:
Expense ratio – An ETF’s expense ratio is taken directly out of net returns. The expense ratio is the sum of all the expenses of the ETF divided by its assets. Internal costs associated with running the fund—including management fees and/or acquired funds’ fees—go into this cost metric. Naturally, the higher the expense ratio, the larger the tracking error.
Diversification Rules – The Securities and Exchange Commission imposes strict diversification rules on ETFs, including one prohibiting an ETF from holding a single security comprising more than 25% of the ETF. For specialized or specific ETFs, at times, this can make it difficult for an ETF to track its index.
Optimization Techniques – Some funds will buy only a subset of stocks that are in the underlying index in an attempt to provide performance similar to the index. “Optimization” might be used when full replication of an index is not possible (e.g., limitation on position concentration or position size, a limited number of shares available on one or more index components). This technique might also be used to lower trading costs. The degree of optimization can affect the size of the tracking error.
Dividend Drag – This occurs when there is cash in a fund. Since no major index is constructed with a cash component, when a dividend is paid on shares inside an ETF, there is a lag between receiving and reinvesting the cash. This error is generally very minimal, but it could potentially be a source of tracking error.
To contrast, mutual funds have all of these reasons for tracking error as well, but may have even higher odds of departing from their stated benchmark performance because they often have higher management fees. Mutual funds also are more likely to have cash drag, as they need cash on hand for redemptions in addition to the cash from dividend drag.
What are Authorized Participants?
Authorized participants (APs) are one of the major parties at the center of the ETF creation/redemption mechanism, and as such, they play a critical role in ETF liquidity. In essence, APs are ETF liquidity providers that have the exclusive right to change the supply of ETF shares on the market.
Authorized participants are typically (but not always) large investment banks, including such firms as BNY Mellon, Citigroup and Goldman Sachs.
Role of Authorized Participants
When an ETF company wants to create new shares of its fund, whether to launch a new product or meet increasing market demand, it turns to an AP, which may be a market maker, a specialist or any other large financial institution. Essentially, it’s someone with a lot of buying power.
It is the AP’s job to acquire the securities that the ETF wants to hold. For instance, if an ETF is designed to track the S&P 500 Index, the AP will buy shares in all the S&P 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a creation unit. These units are usually formed in blocks of 50,000 shares.
The exchange takes place on a one-for-one, fair-value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (NAV), not the market value at which the ETF happens to be trading.
Both parties benefit from the transaction: The ETF provider gets the stocks it needs to track the index, and the AP gets plenty of ETF shares to resell for profit.
The process can also work in reverse. APs can remove ETF shares from the market by purchasing enough of those shares to form a creation unit and then delivering those shares to the ETF issuer. In exchange, APs receive the same value in the underlying securities of the fund.
How It Works
Prior to launch, the issuer will designate one or more APs to the fund. More can sign up over time. The most popular ETFs will have dozens of APs.
An AP’s ability to create and redeem shares helps keep ETFs priced at fair value.
For example, if demand for an ETF increases and a premium develops, APs step in to create more shares and push the ETF’s price back in line with its actual value. If there’s a rush to sell and a discount develops, APs buy ETF shares on the open market and redeem them with the ETF issuers to reduce supply.
Generally, the greater the number of APs for a particular ETF, the better: The force of competition is more likely to keep the ETF trading close to its fair value.
The task set forth for an AP isn’t necessarily an easy one: Sometimes the underlying market that they must access to change the supply of ETF shares is illiquid, or just difficult to access. An exchange-traded product (ETP) tracking the S&P 500 will be easy to access and easily hedge-able for most APs, while one tracking Nigeria equities will be tougher.
Mostly, APs are invisible to individual investors and advisors. Still, it’s good to know they’re there.
What is the Creation/Redemption Mechanism?
The key to understanding how ETFs work is the “creation/ redemption” mechanism. It’s how ETFs gain exposure to the market, and is the “secret sauce” that allows ETFs to be less expensive, more transparent and more tax efficient than traditional mutual funds.
It’s a bit complicated, but worth understanding.
Why It’s Important
The creation/redemption process is important for ETFs in a number of ways. For one, it’s what keeps ETF share prices trading in line with the fund’s underlying NAV.
Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. If many investors want to buy an ETF, for instance, the ETF’s share price might rise above the value of its underlying securities.
When this happens, the authorized participant can jump in to intervene. Recognizing the “overpriced” ETF, the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market. This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit.
Likewise, if the ETF starts trading at a discount to the securities it holds, the AP can snap up 50,000 shares of that ETF on the cheap and redeem them for the underlying securities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a nice profit.
This arbitrage process helps to keep an ETF’s price in line with the value of its underlying portfolio. With multiple APs watching most ETFs, ETF prices typically stay in line with the value of their underlying securities.
This is one of the critical ways in which ETFs differ from closed-end funds. With closed-end funds, no one can create or redeem shares. That’s why you often see closed-end funds trading at massive premiums or discounts to their NAV: There’s no arbitrage mechanism available to keep supply and demand pressures in check.
The ETF arbitrage process doesn’t work perfectly, and it pays to make sure your ETF is trading at fair value. But most of the time, the process works well.
Efficient Way to Access the Market
The other key benefit of the creation/redemption mechanism is that it’s an extraordinarily efficient and fair way for funds to acquire new securities.
As discussed, when investors pour new money into mutual funds, the fund company must take that money and go into the market to buy securities. Along the way, they pay trading spreads and commissions, which ultimately harm returns of the fund. The same thing happens when investors remove money from the fund.
With ETFs, APs do most of the buying and selling. The AP pays all the trading costs and fees, and even pays an additional fee to the ETF provider to cover the paperwork involved in processing all the creation/redemption activity.
The beauty of the system is that the fund is shielded from these costs. Funds may still pay trading fees if they have portfolio turnover due to index changes or rebalances, but the fee for putting new money to work (or redeeming money from the fund) is typically paid by the AP. (Ultimately, investors entering or exiting the ETF pay these costs through the bid/ask spread.)
The system is inherently fairer than the way mutual funds operate. In mutual funds, existing shareholders pay the price when new investors put money to work in a fund or departing investors sell their shares, because the fund bears the trading expense. In ETFs, those costs are borne by the AP (and later by the individual investor looking to enter or exit the fund).
Understanding ETF Liquidity
For individual stocks, liquidity is about trading volume and its regularity—more is better. For ETFs, there’s more to consider.
ETFs are often lauded for their liquidity and single-stock trading characteristics. Truth is, they’re similar.
If an ETF doesn’t trade a certain number of shares per day (e.g., 50,000), the fund is illiquid and should be avoided, right? Wrong. It’s a plausible assumption from a single-stock perspective, but with ETFs, we need to go to a level deeper. The key is to understand the difference between the primary and secondary liquidity of an ETF.
Primary vs. Secondary Market
Most noninstitutional investors transact in the secondary market—which means investors are trading the ETF shares that currently exist. Secondary liquidity is the “on screen” liquidity you see from your brokerage (e.g., volume and spreads), and it’s determined primarily by the volume of ETF shares traded.
However, one of the key features of ETPs is that the supply of shares is flexible—shares can be “created” or “redeemed” to offset changes in demand. Primary liquidity is concerned with how efficient it is to create or redeem shares. Liquidity in one market—primary or secondary—is not indicative of liquidity in the other market.
Another way to make the distinction between the primary market and the secondary market is to understand the participants in each. In the secondary market, investors bargain with each other or with a market maker to trade the existing supply of ETP shares. In contrast, investors in the primary market use an “authorized participant” (AP) to change the supply of ETP shares available—either to offload a large basket of shares (“redeem” shares) or to acquire a large basket of shares (“create” shares).
The determinants of primary market liquidity are different than the determinants of secondary market liquidity. In the secondary market, liquidity is generally a function of the value of ETF shares traded; in the primary market, liquidity is more a function of the value of the underlying shares that back the ETF.
Large Trades Are Different
When placing a large trade—on the scale of tens of thousands of shares—investors are sometimes able to circumvent an illiquid secondary market by using an AP to reach through to the primary market to “create” new ETF shares.
Unfortunately, most of us aren’t trading tens of thousands of shares at a time, so we’re stuck trading in the secondary market. Remember that, to assess secondary market liquidity, you should be looking at statistics such as average spreads, average trading volume, and premiums or discounts (does the ETF trade close to its net asset value?).
It’s really only if you’ll be trading close to 50,000 shares or more at a time that these statistics are no longer the most relevant in assessing liquidity. For those big trades, the liquidity of the ETF’s underlying securities is the most important factor.
After all, to “create” 50,000 shares, the AP must first submit a prespecified basket of the ETF’s underlying securities—a creation basket—to the ETF. There is a direct relationship between the underlying liquidity of an ETF and its primary market liquidity, because in order to create primary market liquidity, the AP must trade in the underlying market—the easier an AP can access the underlying market, the more efficiently she can create and redeem ETF shares.
If you trade this size regularly, a good first step is to contact the ETF issuer itself and request the capital markets desk. One of the main goals of the issuer’s capital markets desk is to ensure that investors enter and exit funds at fair prices. They can also be a great help in providing market impact estimations, underlying liquidity analysis and connecting investors to liquidity providers.
Bond ETFs Explained
Fixed income securities are a mainstay of investor portfolios. While they come in many shapes and sizes, bonds and other fixed income securities are simple in principle—they’re loans from the investing public to an institution that needs money.
Issuers of the bonds are the borrowers, and investors are the lenders. Investors who lend the money expect to be repaid, and they expect to be compensated for the use of their money and the risk they take in making the loan.
Investors’ compensation—the interest on the loan—often takes the form of a regularly paid coupon, say, 5% per year. It’s this coupon payment—a consistent, repeating cash flow—that gives fixed income its name.
The fact that bonds provide a steady cash return and eventually repay all of the original capital (assuming all goes well) gives them a unique role in a portfolio—they provide a steady flow of returns with lower volatility than equity.
However, for years, bonds have been used as a counterbalance to equity investments for another reason: Historically, when stocks go down, bonds often go up, though we’ve seen more of a disconnect in recent years.
But why do bonds “go” anywhere? Don’t they pay regular coupons, as well as return the principal?
In fact, the value of the bond changes over time. Imagine a hypothetical bond’s 5% coupon perfectly compensates the investor at the time of issue. The investor receives $5 per year for the $100 initially lent.
But if inflation shoots up unexpectedly by 2% the year after the bond is issued, the same company might issue nearly identical bonds with a 7% coupon. Suddenly, last year’s bonds with their 5% coupons don’t look very attractive to investors.
Since the coupon is fixed at 5%, the only thing that can reflect the bond’s disadvantage is its market price, which, in this example, will go down—let’s say to $98. The point here is that, while the coupon of the bond is fixed, the bond’s value on the market—and in your portfolio—is not.
The relationship of a bond’s coupon to its current market price is captured in its yield. In our example, the yield of the bond paying the 5% coupon at the time it was issued was also 5%. But when the bond’s market value went down from $100 to $98, the bond’s yield went up. Intuitively, we know that the $5 coupon is more than 5% of the new, lower $98 value.
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The math is a bit more complicated than this, but the idea is that the yield of the bond expresses the value of the coupon payments relative to the current market price of the bond. When the bond’s market price goes down, its yield goes up, and vice versa.
Fixed Income ETFs: The Basics
Like equity ETFs, fixed income ETFs offer exposure to a basket of securities that, in this case, is a basket of bonds. Fixed income ETFs target all corners of the market, from speculative emerging market debt to top-notch U.S. government debt.
There are trade-offs to investing in bonds versus bond ETFs, and the differences from equity ETFs have a lot to do with the fact that bonds don’t trade on exchanges, but over the counter. This means investors can run up against poor market transparency or poor liquidity. But the ETF wrapper means that you’re accessing a basket of bonds that can be traded like a stock.
One thing to consider is that, unless designed to do so, a bond ETF never matures, with bonds entering and leaving the portfolio as they are issued and mature. However, there are target-maturity bond ETFs on the market that invest in bonds maturing in the same year, simulating the behavior of an individual bond and allowing investors to use them for popular bond strategies like laddering.
Because bond ETFs trade on an exchange, they can be more liquid than investing in an individual bond. Bond markets are notoriously illiquid, but bond ETFs trade daily on stock exchanges and can (usually) avoid the illiquidity of bond markets. Additionally, because of their transparency, bond ETFs can contribute to price discovery in bond markets.
The process for picking a fixed income ETF is similar to picking any other asset class. First, you’ll need to determine your targeted exposure—the type of bonds you’re interested in. Next, you’ll need to consider the credit ratings and interest rate risk of the ETF’s underlying securities.
Very broadly speaking, fixed income ETFs fall into four categories:
Sovereign: ETFs targeting fixed income security issues by governments of sovereign nations, U.S. Treasurys and U.K. gilts
Corporate: ETFs targeting fixed income securities issued by corporations
Municipals: ETFs targeting fixed income securities issued by U.S. municipalities
Broad Market: ETFs that have exposure to both sovereign and corporate debt
You’ll also need to consider other criteria like geographic exposure and the construction and methodology of your bond ETF’s underlying index. And if it’s actively managed, you should understand the process its manager uses to select securities.
How Inverse ETFs Work
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Inverse ETFs seek to deliver results that correspond to the inverse, or -100%, of the change in a related index over a specified period of time. Similar to leveraged ETFs, there are inverse ETFs that seek to deliver results over both daily and monthly time periods.
Due to the compounding of returns, the risk and return factors of inverse ETFs will often differ from the experience of simply selling an ETF short. Similar to leveraged ETFs, the performance of inverse ETFs held for longer periods of time than the rebalancing period will depend on the direction of the related index. Consider a daily inverse ETF that’s linked to an index that consistently appreciates (see table).
In this example, the index to which the inverse ETF is linked gains 21.9% during the time period in question. The losses incurred by the inverse ETF are only 18.3%. This occurs because the inverse ETF lowered its exposure after each losing session.
Selling an ETF short would hypothetically expose a client to unlimited losses, since a fund could theoretically experience unlimited appreciation. Achieving short exposure through an inverse ETF limits downside exposure, as the maximum possible loss is the amount of the initial investment.
What are Leveraged ETFs?
Certain products seek to deliver daily results that correspond to the daily change in the index multiplied by the target leverage factor. For example, the ProShares UltraPro S&P 500 (UPRO) seeks daily investment results that correspond to three times (300%) the daily performance of the S&P 500 Index. If the S&P 500 gains 1% during a trading session, UPRO would be expected to appreciate by approximately 3% over the same time period. But the relationship between the leveraged ETF and the underlying index holds only for a specific time period—in the case of UPRO, a single trading session. When leveraged ETFs are held for a period of time either longer than or shorter than the rebalancing period, returns are subject to the impact of compounding. In order to understand the risk/return profile of leveraged ETFs, as well as the potential suitability for a client, it’s important to understand the impact that the daily reset of exposure has on the product.
There are several ways for daily leveraged ETFs to achieve the amount of exposure necessary to deliver these returns. While the exact blend of securities used may vary from fund to fund, most of these products use various derivatives to accomplish the stated objectives. For example, a 2x long S&P 500 ETF may use a combination of equities, futures and swaps to essentially double its exposure. A fund with $100 million in assets might invest $80 million in the underlying assets of the relevant benchmark (in this case the S&P 500), leaving $20 million in cash. A portion of this cash could be used to purchase S&P 500 futures contracts— exchange-traded derivatives that provide exposure to a benchmark without direct ownership. A futures contract is essentially a standardized contract between two parties that agree to buy (and sell) an underlying index at a future date at the market price. The buyer of a contract has a long position in the underlying, while the seller has a short position. A portion of the cash held by the fund could be used as collateral for the futures position.
In addition, a leveraged ETF may enter into an index swap agreement with a counterparty to increase its exposure to the underlying index. Swaps are customized agreements between two counterparties to exchange two sets of cash flows over a specified period of time. In an equity index swap, one party generally pays cash equal to the total return on the underlying index, while the other pays a floating interest rate.
By investing in a combination of these assets, a 2x leveraged ETF can establish $200 million of exposure with $100 million in assets (Figure 1).
The process for constructing a -2x leveraged ETF has some similarities. Because such a fund would be designed to deliver exposure equivalent to a multiple of the inverse return on a benchmark, it could keep a significant portion of its assets in cash, which would be used as collateral for futures and swaps contracts that would increase in value if the related benchmark declined (Figure 2).
Understanding Active ETFs
Active ETFs first came on the scene when a faltering Bear Stearns launched the Bear Stearns Current Yield fund on the American Stock Exchange with the ticker YYY (now used by a fund offered by Amplify ETFs) in 2008. The investment approach was similar to an ultra-short bond strategy.
The fund closed a few months later after its issuer was acquired by J.P. Morgan. But it opened the doors for more similar ETFs.
Until 2020, all actively managed ETFs were technically even more transparent than index-based ETFs because they were required to disclose their holdings daily. Before 2019’s ETF Rule, that was merely a convention for passively managed ETFs, such that almost all issuers disclosed their index-based ETFs’ holdings voluntarily on a daily basis, with Vanguard a notable exception.
Active managers, however, did not flock to the ETF space, partly because they were not comfortable with the required transparency. And the fact that the ability to use custom baskets was not automatically granted to actively managed funds was another sticking point.
During 2019 and 2020, there were two major developments that permanently changed the landscape of the actively managed ETF space.
The ETF Rule
The ETF Rule has been a game changer for the ETF industry since its passage in September 2019. The rule updates the framework governing how ETFs are brought to market and regulated. Not only does the regulation tighten transparency and disclosure requirements, it eliminates the costly, time-consuming “exemptive relief” requirement. It also permits custom baskets for actively managed ETFs, something that previously required additional permissions from the SEC.
The fact that custom baskets were now automatically available to actively managed ETFs was significant. It meant an actively managed ETF could take full advantage of the tax benefits of the ETF structure.
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Typically, an authorized participant will use a creation basket to create new shares of an ETF when needed, or redeem shares of an ETF for its underlying holdings, when the number of shares needs to be reduced. This is often done with a standard basket, which is a proportional reflection of the fund’s holdings.
A custom basket has more leeway and can be used to better manage a fund’s tax exposure. It can hold things like cash or securities that do not directly reflect the broader portfolio. Custom baskets are a key feature of the advantages of an ETF wrapper, as they allow an ETF manager to swap out securities that come with negative tax consequences via a tax-free in-kind transaction.
After the ETF Rule was approved, the floodgates opened for more issuers to enter the market. Many smaller advisory firms have since launched their own actively managed strategies in ETF wrappers, usually through third-party white-label issuers that already have the expertise to bring a new fund to market.
The change also prompted larger issuers to enter the space. For example, Dimensional Fund Advisors, which had declined to launch its own ETFs for years despite investor hopes, converted $30 billion worth of mutual funds into actively managed ETFs in June 2021. The firm has stated that the permissions around custom baskets were a deciding factor.
Nontransparent Actively Managed ETFs
Another game changer for actively managed ETFs occurred in 2020, when “nontransparent” actively managed ETFs made their debut.
This structure was a response to ETFs’ daily portfolio transparency—long an industry tradition that the SEC’s ETF Rule codified into law.
According to the ETF Rule, most issuers are required to publish daily which securities they hold and in what amounts, so investors always know what they hold.
For many active managers, that’s not appealing. Knowing what you own also means that everybody else knows what you own, opening actively managed funds up to front-running or free-riding. As a result, many well-known active managers avoided launching ETFs for years.
Nontransparent actively managed ETFs were in the works for roughly a decade before they came to fruition. Then in May 2019, the SEC granted approval to the first true nontransparent ETF structure, Precidian’s ActiveShares model. The first nontransparent actively managed funds debuted on April 2, 2020, using the Precidian model; they were the American Century Focused Dynamic Growth ETF (FDG) and the American Century Focused Large Cap Value ETF (FLV).
Several other firms have rolled out their own models for nontransparent actively managed ETFs. They include the New York Stock Exchange (in partnership with Natixis), Blue Tractor, T. Rowe Price, Invesco and Eaton Vance.
Differences Between Models
The ActiveShares model from Precidian is unique in that it uses an authorized participant representative (APR) who serves as a go-between for the authorized participant (AP) and the market.
In this model, only the APR and the ETF’s managers know the exact composition of the portfolio, and the “verified intraday indicative value” (“VIIV”), a calculation of the fund’s true net asset value, is published in one-second intervals throughout the trading day. The AP simply delivers cash to the APR in the event of a creation and receives shares of the ETF in return, or the AP receives cash from the APR and delivers shares of the ETF in the event of a redemption to the APR.
Blue Tractor offers another unique spin via its “Shielded Alpha” model. In this case, the actual holdings of the ETF are made public daily. For 90% of those securities, the actual weightings are disclosed daily, but the weightings for the remaining 10% of securities are randomly generated via an algorithm.
The remaining four models rely on proxy portfolios in some form or other that generally include some of the fund’s actual holdings along with other securities that have similar characteristics to the undisclosed holdings. All of the models are required to disclose their actual holdings at least quarterly.
Today there are more than 800 actively managed ETFs; that’s more than a quarter of all U.S.-listed ETFs. That’s up from 234 in mid-2019, a few months before the ETF Rule was approved by the SEC. Back then, only about 10% of ETFs were actively managed. And in mid-2015, there were fewer than 130 actively managed ETFs. So what’s behind the explosion?
Of course, the ETF Rule has been a huge contributor. It removed a lot of the barriers for smaller would-be issuers by codifying much of the process for launching an ETF. And then there’s the added benefit of custom baskets. In addition to giving the likes of Dimensional Fund Advisors reason to enter the market, the ability to fully access the benefits of the ETF structure also attracted numerous advisory firms to package some of their existing active strategies in an ETF wrapper.
Nontransparent active ETFs have been far less prevalent than their transparent brethren. Despite the decade-long wait for such products, once they actually debuted, they didn’t really take off, compared to the scores of transparent active ETFs that have launched since those first funds from American Century. Nearly two years on, there are only about 50 nontransparent active ETFs currently trading, with roughly $5 billion in total assets under management.
And let’s not forget about defined outcome ETFs, which offer buffered exposure to an underlying index, but are nevertheless classified as actively managed. The funds rely on actively managed options strategies to achieve their goals, and the first one made its debut in 2018. The field has since grown to 145 ETFs, representing $11.5 billion in value.
Finally, while the lion’s share of ETF assets flow into passively managed products, the low-hanging fruit in that area has been plucked. There are very few ways to innovate in the ETF space any further with indexes, unless you have a unique smart beta or thematic concept. Active strategies are one of the few categories where there’s room to introduce unique or innovative investment ideas.
Beyond Broad Equity: ETFs You May Encounter
Environmental, social and governance strategies have exploded since the pandemic. Currently, the category (found under the Socially Responsible channel on ETF.com), has roughly $109 billion in assets under management spread across more than 180 ETFs.
The category, however, includes far more than funds that simply rely on metrics around the three pillars of the ESG rubric. It encompasses funds that: screen companies based on the values of different religions; specifically home in on concerns like climate change or clean energy; or promote causes such as racial and gender equality.
Although ESG is the most widely recognized term, other terms for funds that screen based on values or other nonfinancial criteria can include “socially responsible,” “impact investing” and “sustainable investing.”
With traditional ESG investing, companies with significant business activities in areas such as fossil fuels, weapons, alcohol or gambling are often excluded. One of the largest historical criticisms of ESG investing has been that investors give up performance by limiting where they invest.
However, during the pandemic, ESG strategies have tended to outperform. And during 2020 and 2021, the category exploded, with more than 80 ESG ETFs added to the marketplace. That’s roughly 45% of the entire ESG universe, and leading issuers have pledged to roll out even more funds that fit ESG criteria to meet increasing demand.
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Defined Outcome ETFs
The first defined outcome ETF launched on the market in 2018. Since then, the field has grown to encompass roughly 145 ETFs, with more than $11 billion in assets under management.
All of these funds are actively managed and generally use flexible exchange (FLEX) options tied to indexes or passively managed ETFs to achieve their stated goals. Although there are some differences in how they operate and variation in goals, generally, the funds provide a limited amount of upside tied to the performance of their target index/ETF while protecting against downside performance up to a certain percentage.
For example, the $536 million Innovator U.S. Equity Power Buffer ETF – January (PJAN) resets every Jan. 1. On that date, the fund resets its static buffer against a 15% decline and its upside cap.
As of Jan. 1, 2022, the upside cap, determined by the pricing of the options at that time, is 8.99% before expenses. That means over the one-year period until its next reset, the fund could go up as much as 8.20% (once you take into account its 0.79% expense ratio), or that its reference benchmark could decline as much as 14.21% after expenses before the fund sees any downside loss.
Other funds have different reset dates, different buffers and use different types of FLEX options to achieve their goals, but the concept is the same across funds. Many view these funds as potential substitutes for fixed income at a time where interest rates are extremely low, or believe they can be used to manage retirement assets.
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Commodities are generally raw materials falling under the designation of metals, agricultural products or energy sources. It’s a category that has undergone a significant evolution over the years, and it’s currently represented by 107 ETFs and ETNs holding roughly $150 billion in assets under management.
Many investors see them as a great diversifier for equity and fixed income portfolios, especially after the commodity boom that characterized the early years of the 21st century.
From an ETF perspective, there are two types: futures-based or physical. Physical ETFs tend to involve precious metals, which are relatively easy to store, unlike natural gas or wheat. They allow investors to access the coveted “spot price,” which is the current price of the commodity as it trades in the market.
Other commodity ETFs or ETNs hold futures contracts that represent ownership of a particular commodity at a future price; however, the funds never take delivery of those commodities. Instead, they roll the assets directly into contracts that expire later.
Most futures-based commodity ETFs roll into front-month contracts, but some have methodologies that allow them to roll into others at different locations along the futures curve. It should be noted that the costs of rolling to new contracts are a significant drawback of futures-based funds.
There are two terms to understand when it comes to futures-based commodity ETFs: contango and backwardation.
When a futures market is in contango, the price of the commodity for future delivery is higher than the spot price (longer-dated futures prices are higher than near-dated futures). A chart plotting the price of futures contracts over time is upward-sloping. When a futures market is in backwardation, the opposite occurs (far-dated futures are lower than the spot or near-term futures price). A chart plotting the price of futures contracts over time is downward-sloping. Backwardation is the more desirable trend for an investor in futures-based ETFs or ETNs.
While most commodity ETFs are index-based, there are quite a few that are actively managed.
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“Thematic” can refer to a fund that represents a small slice of a broad sector (just as cybersecurity is a subset of technology) or it can refer to a wide-ranging fund that crosses sectors to select securities fitting the targeted theme (such as an ETF focused on a concept like innovation or infrastructure).
These ETFs have taken off, as the low-hanging fruit of core asset classes have been covered by established ETF issuers. The rise of the internet has also been a driver, as it has created a host of burgeoning categories, such as online commerce, streaming, online betting and gaming, which don’t necessarily fit neatly into a traditional sector structure.
Currently, ETF.com classifies 267 ETFs as falling under the “theme investing” category. A quick look at the largest members of the category includes funds that home in on cybersecurity, clean energy, infrastructure and internet firms, among other areas of focus.
The drawbacks of these funds tend to be that they can be narrow in scope, with small and illiquid holdings, which can contribute to volatility. However, for someone with a strong conviction about a particular theme, the potential for diversification and alpha can be very attractive.
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Bitcoin Futures ETFs
Cryptocurrency is all the rage these days, and bitcoin is the best known and largest of the cryptos available. It’s no surprise that there’s a significant amount of demand for an ETF that holds bitcoin.
In fact, the first filing for a physical bitcoin ETF was made in 2013, but there was little to no movement until several years later. Physical bitcoin ETFs were consistently rejected by the SEC, but after a lot of iterations and consultation, a bitcoin futures ETF was approved to launch.
The ProShares Bitcoin Strategy ETF (BITO) hit the market in October 2021 to much fanfare, and surpassed the $1 billion in assets mark after just two days of trading (with the drop in bitcoin price, it’s less than that currently). It was rapidly followed by the Valkyrie Bitcoin Strategy ETF (BTF), which has seen less success and currently holds about $39 million in assets.
As of mid-February 2022, the SEC has not approved a physical bitcoin ETF.