ETF University: 2019

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?

Want to Know How ETFs Work? First Understand How Mutual Funds Work
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 who has 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. Whammo-presto: 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 close to 100 years. They currently provide exposure to stocks, bonds, commodities and other assets.

But What About ETFs?
All that’s great, but you’re not reading this to learn about mutual funds. You want to learn about ETFs.

So what is an ETF? Well, it’s 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 mutual fund in every aspect … except one.

And that’s a big one, which is hinted at in its very name: exchange-traded funds.

Being Exchange-Traded
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 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.

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.

It’s like a mutual fund 2.0.

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, 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 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 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.

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.

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 Do APs Gain the Right to Change the Supply of ETP Shares?
ETP issuers decide. Prior to launch, the issuer will designate one or more AP to the fund. More can sign up over time. The most popular ETFs will have dozens of APs.

How Do APs Impact Liquidity?
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 is not 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 tracking the S&P 500 will be easy to access and easily hedge-able for most APs, while one tracking Nigeria equities will be tough.

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.

An 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 more fair 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.

An ETF Isn’t a Stock
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.

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.

Understanding Net Asset Value

When selling a car, people don’t accept the first price a used-car salesman quotes as its actual value. Instead, most attempt to arrive at a more independent assessment of actual value.

That can be tough with a used car. Fortunately, it’s very easy with ETFs—it’s calculated and disseminated to the public daily. This “value” is termed net asset value (NAV), and it’s one of the most important data points for ETFs and mutual funds.

A fund’s NAV is the sum of all its assets (the value of its holdings in cash, shares, bonds, financial derivatives and other securities) less any liabilities, all divided by the number of shares outstanding.

It’s basically an indication of the fair value of a single share of the fund. It provides investors a reference point around which they can gauge any offers to buy or sell shares of the fund. Because of the creation/redemption mechanism, ETFs tend to trade very close to their NAV.

At this point, it’s clear that NAV is an important and useful metric for investors, but like most things in life, there are exceptions to its utility. So, when is NAV inadequate? How does NAV become “stale”?

To answer these questions, we need a brief overview of how NAV is calculated.

How Is NAV Calculated?
To establish a daily NAV, the fund chooses a time, every day, at which to value its assets. For a traditional equity ETF, the NAV is calculated (or “struck”) once all the markets being tracked by the ETF’s index have closed.

For an ETF tracking U.S. equities, for example, the NAV can be calculated soon after the U.S. market’s 4:00 p.m. ET close. At that time, the closing price of each of the fund’s assets is recorded as an indication of its current value. All these prices are then aggregated to arrive at the value of the fund’s entire portfolio.

NAV’s Shortcomings
Challenges arise when an ETF holds securities trading in a different time zone, because NAV is based on the last price when the exchange closes. A lot can happen in the hours when an ETF is trading but its securities aren’t. In such cases, NAV will remain stationary because the foreign exchange is closed, and only the ETF will reflect any changes in value over that time.

If the value has changed, but NAV has not, as a result, NAV is “stale,” and differences between the ETF’s trading price and its NAV can appear.

Using closing exchange prices is all well and good for equity securities, but what about bonds?

For bond ETFs, bid prices (the price at which the ETF could sell its bonds) are often used, meaning that the NAV may seem lower than a valuation based on midpoint or offer prices.

iNAV
Distinct from an ETF’s official, once-a-day NAV is the intraday or indicative NAV (often called “iNAV”). This is a measure of an ETF’s intraday value, with the prices used in the NAV calculation updated for real-time market movements, and published several times a minute.

iNAVs are often calculated by third-party commercial data vendors. Many stockbrokers offer their clients access to real-time iNAVs on ETFs, which can then be compared with ETF prices.

iNAVs can be a useful measure of value when you’re looking to trade an ETF, although they’re not foolproof, and similar to NAVs, may not reflect true value if prices become stale.

The Different Types of Trades

Whether you trade a single ETF share at a time or thousands, how you order trades matters. Three main order types exist: market order, limit order and stop order. Here are the pros and cons of each.

Market Order
A market order is an order to buy or sell an ETF right now. The order executes immediately, at whatever the best available price may be.

With a market order, speed outranks price. That’s fine for highly liquid, high-volume ETFs, but it can be a recipe for disaster for volatile or less liquid funds.

Limit Order
A limit order establishes a maximum or minimum price at which you’re willing to trade an ETF. The order only executes if the ETF’s share price meets that target (or better). A buy limit order for $5/share, for example, means you’ll only buy if the ETF hits $5 or below.

With limit orders, you can set boundaries over trades to ensure you don’t pay more or receive less for shares than you want. But they aren’t guaranteed to execute. If, per our example, the ETF’s price never falls to $5, then your limit order would never execute and you’d never get your shares.

Still, “a limit order is a good idea any time you’re trading a particularly large size, whether in shares or in market value,” said Blair duQuesnay, now an investment advisor and financial planner at Ritholtz Wealth Management. “You want to make sure the order you’re putting in isn’t going to move the price.”

Stop Order
A stop order is a market order that only activates if the ETF in question reaches a particular price (the “stop price”).

A sell-stop order for $5/share, for example, only activates if the ETF’s share price hits $5, after which your shares then sell for whatever the best available market price may be.

A sell-stop order is sometimes referred to as a “stop loss” order, because using one ostensibly protects your profits from further losses. (However, there’s nothing about a stop-loss order that saves you from losing money due to bad execution.)

Like limit orders, stop orders establish boundaries regarding what prices you are and aren’t willing to accept. That’s helpful if you can’t or don’t want to track the market minute by minute, but you still need protection from sudden swings.

Keep in mind that your stop price isn’t your trading price. The stop price is just a trigger—once the trade activates, it then becomes a market order.

Furthermore, if an ETF grows volatile, your stop order might trigger before you want it to. This is especially true for illiquid markets, where ETF prices can sometimes drift from net asset value for hours at a time before ultimately correcting.

Stop-Limit Order
A stop-limit order combines stop and limit orders in an automated process. Once an ETF’s share price hits the stop price, the trade activates and is executed as a limit order (meaning, it doesn’t fill until it reaches the limit price or better).

For example, for a sell-stop-limit order with a stop price of $5 and a limit price of $4.50, your order activates as soon as the ETF’s price falls to $5. But your shares are only sold if they’re above $4.50.

That means everything is fine if the price is moving by small increments, like a penny or two.

If the price drops to $4.49 from $5.00, your order will have been activated by the fall to $5.00 (the stop part), but it won’t fill (the limit part). And if the price is in full-on free fall and it gaps down to, say, $3.00 or even $1.00, your order will not have gone through, and you’ll be left holding shares you probably don’t want.

However, as with a limit order, you may not find someone willing to pay your limit price. Further, ETFs don’t always move incrementally. If the price spikes or plunges, your stop price might be triggered but the limit order might never be filled.

If, in our above example, the ETF price gapped down to $3, the stop-limit order will still activate, but the limit order can’t execute until the ETF’s price rises back above $4.50. Thus, the trade won’t execute—and never will, so long as the ETF stays below $4.50.

Market orders are usually safe if you’re mostly trading large, liquid ETFs. If you want to protect against potential downside risk, however, a limit order is usually safer. And stop orders should always be used with care lest you get caught in an arbitrary pricing movement.

Understanding Spreads & Volume

ETFs trade like stocks. ETFs trade nothing at all like stocks. Both of these statements are true. But to trade ETFs, you should know why this is so.

The Bid/Ask Spread
The place to start with understanding how ETFs trade is to understand how individual stocks trade.

At any given time, there are two prices for any common stock: the price at which someone is willing to buy that stock (the “bid”) and the price at which someone is willing to sell (the “ask”). The difference between these two prices is called the “spread.”

The reason spreads exist is because, in any open market, folks try to negotiate the best prices they can get. If you’re looking to buy, you’ll naturally want to see if someone is willing to sell for less than the last traded price.

Conversely, if you’re selling, you’ll naturally hope that someone will be willing to buy it for more than the last quoted price. Spreads are simply the result of buyers and sellers negotiating on prices.

For example, let’s imagine Microsoft’s stock is trading with the bid at $49.90 and the offer at $50.10. The spread is therefore $0.20. If someone asked you what a share of MSFT was “worth,” you’d probably choose the midpoint: $50.00, or maybe the last price at which you can see a trade actually happened.

But if you wanted to buy MSFT right now, you’d probably have to pay $50.10. If you wanted to sell right now, all you’d get is $49.90. Those are the prices you’d get if you enter a market order into your brokerage window.

The wider the spread, the more it will cost you to trade MSFT.

Bid/ask spreads are so important to ETP trading because, unlike a mutual fund—which you buy and sell at net asset value—all ETFs trade like single stocks, so ETFs trade with bid/ask spreads. That’s the price of the “exchange-traded” in the name.

Spreads widen and narrow for various reasons. If the ETF is popular and trades with robust volume, then bid/ask spreads tend to be narrower. But if the ETF is thinly traded, or if the underlying securities of the fund are highly illiquid, that can also lead to wider spreads.

Overall, the narrower the bid/ask spread, the lower the cost to trade.

Volume & Market Impact
However, when trading stocks or ETFs, you also have to look at volume and so-called market impact.

Volume is the number of shares that trade on any given day. The higher the volume, the better. For example, if MSFT trades, on average, 10 million shares per day, it’ll be easier to trade than something that trades 100 shares per day. Note, however, that spreads could be tight on both, which could mislead unwitting investors to conclude that both securities are equally liquid.

Typically, the number of shares offered on the “bid” or the “ask” will be small—sometimes 100 shares, sometimes more, but rarely a huge amount. If you try to buy 10,000 shares of something that only trades 100 shares per day, you could have trouble.

To go back to our MSFT example, someone might be willing to sell you 100 shares of MSFT at $50.10, but if you want to buy 10,000 shares, you might have to pay $50.25 or more. The amount that you drive up the price of something you are trying to buy is called the “market impact.”

How Does That Impact ETF Trading & How Are ETFs Different?
Because ETFs trade on exchanges like stocks, they have bid/ask spreads, volumes and potential market impact, too. All else equal, you’ll do better trading something that has high volume and a tight bid/ask spread. In this way, trading ETFs is just like trading a stock.

But ETFs have a critical difference that dramatically alters the playing field for investors.

With single stocks, there’s no way to create new shares. But institutional investors called authorized participants (APs) are allowed to create new shares of an ETF to meet demand. So if you want to buy a lot of an ETF … say, 50,000 shares … an AP might create those shares to fill your order.

ETF Costs Beyond the Expense Ratio

An ETF’s expense ratio is an easy-to-understand, flat annual fee that helps you weigh the relative expense of one fund versus another.

But expense ratios alone don’t tell you the full story about how much an ETF really costs. To own any given fund, you’ll pay much more than just an annual management fee, including ...

Trading Commissions
A commission is what your brokerage takes for making your trade. You pay this fee every time you buy and sell shares, no matter how big or small your trade (though sometimes a discounted rate is offered to more frequent traders).

Commissions depend on a variety of factors, including the brokerage you select, what kind of account you hold and whether you order in person, over the phone or online.

One thing’s certain, though: The more frequently you trade, the more you’ll pay in commissions, and that can erode your bottom line.

The good news is that many brokerages—such as Charles Schwab and TD Ameritrade—now offer commission-free ETF trading for certain funds. Still, exclusions sometimes apply, so make sure you read the fine print before investing.

Bid/Ask Spreads
Technically, an ETF’s market price is not singular. Two prices actually matter: the price at which you can find a buyer to take your shares, and the price at which a seller will give them to you. These are the “bid” and “ask” prices, respectively, and the difference between them is known as a “bid/ask spread.”

The bid is usually lower than the ETF’s current share price, while the ask is usually higher. You’ll pay the full spread on every round-trip trade you make; meaning, the more frequently you trade shares, the more bid/ask spreads will cost you.

Several factors dictate the size of an ETF’s bid/ask spread, including the liquidity of the underlying securities, how expensive it is for fund managers and market makers to offset risk, and the total supply/demand of actual ETF shares.

But like commissions, bid/ask spreads are unavoidable. You pay the current bid when you enter a fund and the current ask when you exit it.

Premiums/Discounts
An ETF trades at a premium when its market price exceeds the sum total of all the prices of its underlying holdings. An ETF trades at a discount when the reverse is true, and the ETF’s price falls below that of its underlying holdings.

By themselves, premiums and discounts don’t cost you anything. If you buy and sell your shares at the same 0.50%, then the net effect on your returns is zero.

Premiums and discounts only cost you if they change between the time you buy and the time you sell. If that 0.50% premium instead becomes a 0.50% discount, then you’ll lose 1% total on the round trip (assuming no price change).

ETF critics like to sound the alarm over premiums and discounts, but they’re actually normal. Most ETFs regularly carry small premiums or discounts, which arise organically from the supply/demand pressures that govern all marketplaces. (They can also emerge in other situations, such as when an ETF’s trading hours don’t match those of its underlying securities, as with some international funds.)

Plus, should premiums and discounts ever grow too large, ETFs have a built-in mechanism to realign prices with value through the creation/redemption process and the authorized participants that drive it.

Tallying Costs
What cost affects you most depends on which kind of investor you are. Expense ratios impact buy-and-hold investors far more than active traders, who in turn are more impacted by commissions and bid/ask spreads. Premiums/discounts, though, are a wild card that can either help or hinder, depending on their value at trading time.

Understanding Securities Lending

Securities lending is a fairly simple process that can generate extra returns for ETF investors, but it also introduces extra risk—however minimal.

The logic behind securities lending is this: An equity ETF will typically hold thousands of shares of various stocks. If there is a short-seller out there who wants to borrow those stocks—and agrees to post collateral and pay the ETF a fee for doing so—why not lend them out and make a little extra dough?

Generally speaking, securities-lending activities are positives for shareholders and contribute to tighter index tracking and better overall returns. They’re not without some risks; while we believe they’re generally minor, they’re nonetheless worth considering.

Risks of Securities Lending
You’d think the biggest risk in securities lending is that the short-seller you lent shares to goes bankrupt. Fortunately, industry practice is for borrowers to provide collateral exceeding the value of the loaned securities by a set margin. So while a busted counterparty is a pain, it’s not immediately costly.

The costs come in if the borrower is a short-seller (it usually is) and the security that they shorted rallies strongly in a single day, the borrower defaults and the provided collateral is insufficient to cover the cost of reacquiring the security. Remember, collateral balances are only settled (at best) daily.

Even that is small-fry, however.

The real risk with securities lending is that when ETF issuers receive cash collateral, they don’t just sit on it—they put it into money market securities to earn some small amount of interest on the cash. Where firms get into trouble is when these collateral investments go bankrupt, such as when Lehman Brothers went under. It’s unlikely, but it has happened.

How Profitable Is Securities Lending?
It depends. Just as prices in the rest of the economy are subject to the forces of supply and demand, so too are securities-lending premiums.

Securities that are in high demand in the loan market command higher premiums. ETFs that hold these in-demand securities can earn a significant premium lending out portfolio holdings. Premiums tend to fluctuate as certain sectors, markets or countries fall in and out of favor with short-sellers.

When these factors align perfectly, ETFs can earn huge premiums for lending securities. Historically, some ETFs (those in solar in 2017, for instance) have paid dividends amounting to a yield as high as 5-7%, despite the fact that none of their underlying holdings paid dividends. In these cases, the ETF generated sufficient revenues from securities lending alone to enable a hefty dividend for its investors.

Let’s keep things in perspective though; most ETFs don’t earn such lofty premiums for lending their securities. While they certainly provide a tail wind for ETFs, the effect of securities-lending revenue is usually relatively muted and generally serves to offset expenses rather than generate significant outperformance.

It’s worth noting that, rather than distributing securities-lending revenue as dividends, the usual course of business is for ETFs to invest the extra revenue in its portfolio holdings. In this case, investors reap the rewards via fund performance rather than dividend payments.

The takeaway is that securities lending introduces some risk to ETF portfolios—much of which has been mitigated by issuer policies. Meanwhile, the benefits of securities lending range from negligible to highly significant.

Legal Structures, Regulations & Taxes

Investors spend hours researching funds for expense ratios and spreads, trying to save a few basis points here and there. But often, not enough time is spent researching a fund’s structure and the associated tax implications, which can translate into hundreds or even thousands of basis points.

An ETF’s taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an ETF’s tax treatment inherently depends on both the asset class it covers and its particular structure.

A fund’s asset class can be classified in one of five categories: equities; fixed income; commodities; currencies; and alternatives.

For tax purposes, exchange-traded products come in one of five structures: open-end funds; unit investment trusts (UITs); grantor trusts; limited partnerships (LPs); and exchange-traded notes (ETNs).

Many commodity and currency funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodity pools, but they’re classified as LPs for tax purposes by the IRS. Therefore, “limited partnership” is used to refer to the structure of these funds with regard to taxation.

This five-by-five matrix—five asset classes and five fund structures—defines the potential tax treatments available in the ETF space.

Equity & Fixed-Income Funds
Equity and fixed-income ETFs currently operate in three different structures: open-end funds, UITs or ETNs.

Commodity Funds
Commodity ETFs come in one of four structures: open-end funds, grantor trusts, LPs or ETNs.

Currency Funds
Currency ETFs come in one of four structures: open-end funds, grantor trusts, LPs or ETNs.

Alternative Funds
Alternative funds come in one of three structures: open-end funds, LPs or ETNs. (Alternative funds seek to provide diversification by combining asset classes or investing in nontraditional assets.)

Taxation of Distributions
Besides taxes on capital gains incurred from selling shares of ETFs, investors are also subject to paying taxes on periodic distributions, which can be dividends paid out from the underlying stock holdings, interest from bond holdings, return of capital (ROC) or capital gains—which come in two forms: long-term gains and short-term gains.

Dividend payments from ETFs are usually paid out monthly, quarterly, semiannually or annually. There are two kinds of dividends that investors should be aware of: qualified dividends, and nonqualified dividends.

Qualified dividends are dividends paid out from a U.S. company whose shares have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Importantly, this refers to the shares held by the ETF itself, and not the holding period of investors in the ETF.

Investors should keep in mind that while monthly distributions from bond ETFs are often called “dividends,” interest from the underlying bond holdings aren’t considered qualified dividends, and are taxed as ordinary income.

Funds can also pay out distributions in excess of the fund’s earnings and profits (ROC). ROC is generally nontaxable and reduces the investor’s cost basis by the amount of the distribution.

Medicare Surcharge Tax
Effective Jan. 1, 2013, singles with an adjusted gross income (AGI) of more than $200,000, and those married filing jointly with an AGI of more than $250,000, are now subject to an additional 3.8% Medicare surcharge tax on investment income, which includes all capital gains, interest and dividends.

This tax is levied on the lesser of net investment income or modified AGI in excess of $200,000 single/$250,000 joint. Therefore, for investors in the highest tax brackets, their “true” tax rates on long-term capital gains and qualified dividends can reach 23.8% (20% capital gains plus 3.8% Medicare tax).

Disclaimer: We are not professional tax advisors. This article is for informational purposes only and not intended to be tax advice. Tax rules can change. Individuals should always consult with a professional tax advisor for details about the tax implications of investment products and their personal taxes. Pending or future legislation could materially affect the information in this article.

How Transparent Are ETFs?

One of the key benefits of ETFs is that they offer better transparency into their holdings than competing mutual funds. The ability to verify your positions on a daily basis (in most cases) is a big plus.

By law and by custom, mutual funds are only required to disclose their portfolios on a quarterly basis—and then only with a 30-day lag. In between reporting periods, investors have no idea if the mutual fund is invested according to its prospectus, or if the manager has taken on unwanted risks. Mutual funds can and do stray from their described targets—a phenomenon known as “style drift”—which can negatively impact an investor’s asset allocation plan.

ETFs are far more transparent. By custom, most ETFs disclose their full portfolios on public, free websites every single day of the year. You can see regularly updated ETF portfolios at ETF.com, too.

There’s no law requiring that ETFs disclose their full portfolios every day. But even for those that disclose less frequently, there is a catch.

ETF issuers each day publish the lists of what securities an authorized participant must deliver to the ETF to create new shares (“creation baskets”), as well as what shares they’ll get if they redeem shares from the ETF (“redemption baskets”). This—combined with the ability to see the full holdings of the index an ETF is aiming to track—provides an extremely high level of disclosure even for those few ETFs that fall short of the daily-disclosure ideal.

Of note: All “actively managed” ETFs must, by law, disclose their full portfolios every day. They are actually the most transparent of all ETFs.

Managing & Avoiding ETF Closures

Like any business, even low-cost ETFs need to generate revenue to cover their costs.

Plenty of ETFs fail to garner the assets necessary to cover these costs and, consequently, ETF closures happen regularly. In fact, a significant percentage of ETFs are always at risk of closure. There’s no need to panic though: Broadly speaking, ETF investors don’t lose their investment when an ETF closes. A closure can, however, be inconvenient and costly.

The good news is that for each high-closure-risk ETF out there, there is almost always a larger, more viable product available to suit your investment needs.

What Happens When an ETF Closes?
Once the decision to delist or liquidate an ETF has been made, a prospectus supplement will state the ETF’s last trading date and its liquidation date (if it has one).

At this point, or soon after, “business as usual” ceases, and the fund halts creations as it prepares to convert to cash. This causes ETF performance to diverge from the performance of its underlying index.

During this period, the ETF issuer will continue to publish indicative net asset value (iNAV) throughout the day, and it should still be referenced when buying or, more likely, selling the ETF. It’s generally advisable to sell any remaining shares you may be holding before the last day of trading.

Delisting vs. Liquidation
When an ETF liquidates, investors generally receive cash distributions equal to NAV, so even if you fall asleep at the wheel, you’ll receive the fair value of your shares. Over the years, there’ve been a few instances where the process wasn’t smooth, but exceptions aside, liquidation is likely to be a less costly and cumbersome affair than delisting.

When an ETF delists without liquidating its portfolio, investors who fail to sell their shares before the last trading date will be forced to trade over the counter—generally more complicated and costly.

Downside of Closures
Even if the delisting and closure goes smoothly, it can still be hugely inconvenient, for a few reasons.

Reputation Risk: From the perspective of advisors, avoiding funds at high risk of closure can help avoid egg-on-your-face phone calls to clients after recommending a fund that’s now closing: “Remember that great ETF I told you about? About that, ... “

Reinvestment Risk: When an ETF delists or liquidates, it creates reinvestment risk for its investors—not to mention the extra and unnecessary burden associated with reinvesting. Once you receive your cash-equivalent NAV, you’ve got to find somewhere else to put it, which could mean repeating the entire process that landed you in the ETF to begin with.

Tax Burden: Since investors must either sell their shares or receive cash equivalents of NAV, they’re forced to realize any capital gains. Realizing capital gains earlier than planned can create an unanticipated tax burden.

Closure Risk Factors
It’s relatively easy to predict likely candidates for closing, and a little homework can be good insurance.

Low Assets Under Management: Low AUM is one of the best indicators of closure risk. Funds with hundreds of millions of dollars are too profitable to close.

The only problem with using AUM as an indicator of fund-closure risk is that you’re ruling out far too many ETFs. There are hundreds of ETFs with low AUM that don’t close each year—and some of them are great products.

Still, as a general rule of thumb, once a fund surpasses the $50 million mark in AUM, it’s far less likely to close.

Issuer Strength: Surprisingly, even more important than AUM in predicting fund closure is the strength of its issuer. Indeed, most ETF closures historically are the result of entire companies getting out of the ETF business, not big issuers simply closing ETFs that are slow out of the gate.

Consequently, when evaluating whether a low-AUM fund is at risk of closure, consider the strength of its issuer as well as the issuer’s history and general culture surrounding closures.

Fund Rank In Segment: If a particular ETF is the least popular (by AUM) among 10 ETFs that offer similar exposure, it’s more likely to close than a similarly unpopular ETF that’s the only ETF offering exposure to a particular sector/country/strategy. Essentially, unpopular funds in oversaturated markets are at greater closure risk than unpopular funds offering unique exposure.

Summary
Ultimately, don’t let media headlines about ETF closures invoke fear because, first and foremost, ETF investors usually don’t stand to lose when an ETF closes. Secondly, funds at risk of closure are largely easy to identify, which is to say that it should be easy for you to avoid the high-risk funds.

Fixed-Income ETFs During a Panic

ETFs typically trade at something close to “fair value.” That is, if you calculated the intraday value of all the securities an ETF holds, that would roughly align with the price of the ETF.

The process that keeps ETFs trading at “fair value” is the creation/ redemption mechanism (explained on page 13). If, at any time, the price of the ETF deviates from the price of the underlying portfolio, institutional investors can swoop in and arbitrage the difference.

There are various ways and places that this near-perfect relationship gets upset. The most high-profile—and important—is in fixed income. Fixed-income ETFs—particularly in times of stress—can trade to massive premiums or discounts to their net asset values (NAVs).

The question this article aims to answer is: Is this a problem with the ETF or a problem with the underlying bond market?

Bond Market Is Different
Compared with stocks—like those in the S&P 500, which trade throughout the day on the NYSE and Nasdaq—bonds are relatively illiquid, and their true price is harder to know with certainty. For example, shares of Apple are fungible, so the last price at which a share was traded is a very good representation of the current value of every Apple share. The bond market is different.

First, bonds trade much less frequently than stocks—so the last traded price might not be current at all. Second, they don’t trade on an exchange: Most bond trades are individual “over the counter” agreements between two parties. Third, bonds come in much greater variety than stocks; for example, Exxon has many bond issues, each with different maturities and coupons, and each requiring its own price. Fourth, ETF issuers generally rely on bond pricing services for “fair” value estimations of their holdings; these estimations are based on the current selling price the fund might receive were it to start selling its bonds immediately. That fire-sale price will always be less than what you could pay to buy the bond, so there’s a “natural” depression in the reported NAV of all bond ETFs.

For all of these reasons, it’s not uncommon that a highly liquid bond ETF can serve as price discovery for the true fair value of the basket of bonds it holds. In other words, the market price of the bond ETF can be a better approximation of the aggregate value of the ETF’s underlying basket bonds than its own NAV. Therefore, large premiums and discounts do not necessarily signal any mispricing in the ETF.

Price Discovery & the ETF Wrapper
The idea of price discovery—where the ETF’s market price is actually “ahead” of its NAV and is the best representation of fair value—shows up in other corners of the ETF world. For example, imagine a Japanese equity fund. The underlying stocks trade in Tokyo during their day, but the ETF trades throughout the U.S. trading day. Negative Japan news occurring in the morning here in the U.S. after the Tokyo market closes will depress the ETF share price, but its NAV will be unchanged, producing a large discount on that day.

To be clear, large premiums and discounts can’t be safely ignored in all cases, and ETF share prices aren’t always in the right when they don’t match NAV. Sometimes large premiums and discounts signal that the ETF itself trades poorly and is therefore a lousy price-discovery vehicle. Still, the relative illiquidity of the bond market means that bond ETF premiums and discounts can’t be relied upon blindly.

One general rule: A bond ETF is likely to be an efficient price-discovery vehicle—and therefore indicate that any large premiums and discounts aren’t a sign of trouble—if the ETF’s shares trade with great frequency and high volume.

Bonds vs. Bond ETFs

Bonds are great. They offer safe, steady and predictable returns that have low correlations to stocks, making them an excellent way to balance higher-risk equities in a portfolio. But for the average investor, investing in individual bonds is next to impossible.

Downsides of Buying Bonds
Investing in single bonds is difficult for many investors, due to:

• Poor market transparency. Bonds trade over-the-counter (OTC), meaning there’s no single exchange on which they trade and no official agreed-upon price. The market is difficult to navigate, and investors may find they receive widely different prices from different brokers for the same bond.
• High markups. Broker markups on bond prices can be substantial, especially for smaller investors; one U.S. government study found that markups on municipal bonds can soar as high as 2.5%. Between these markups, bid/ask spreads and the price of the bonds themselves, the cost to invest in individual bonds can add up—fast.
• Poor liquidity. Bonds vary widely in their liquidity. Some bonds trade daily, while others only trade weekly, or even monthly—and that’s when markets work perfectly. In times of market distress, some bonds may stop trading altogether.

What Are Bond ETFs?
A bond ETF is a bond investment in a stocklike wrapper. A bond ETF tracks an index of bonds and tries to replicate its returns. Though these instruments hold bonds and only bonds, they trade on an exchange like stocks, giving them some attractive equitylike properties.

Differences Between Bonds & Bond ETFs
Bonds and bond ETFs may comprise the same basic investments, but exchange trading changes the behavior of bond ETFs in several important ways:

• Bond ETFs do not mature. Individual bonds have a fixed, unchanging date at which they mature and investors get their money back; each day invested is one day closer to that result. Bond ETFs, however, maintain a constant maturity, which is the weighted average of the maturities of all the bonds in its portfolio. At any given time, some of these bonds may be expiring or exiting the age range that a bond ETF is targeting (e.g., a one- to three-year Treasury bond ETF kicks out all bonds with less than 12 months to maturity). As a result, additional bonds are continually being bought and sold to keep the portfolio’s maturity constant.
• Bond ETFs are liquid even in illiquid markets. The tradability of single bonds varies widely. Some issues trade daily, while others can trade as little as once a month. In times of stress, they may not trade at all. In contrast, bond ETFs trade on an exchange, meaning they can be bought and sold at any time during market hours, even if the underlying bonds themselves are not trading at the time.

  This has very real effects. For example, one source found that, on average, high-yield corporate bonds trade fewer than half the days each month; meanwhile, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) trades millions of shares each day.

• Bond ETFs pay out monthly income. One of bonds’ biggest benefits is that they pay out interest to investors on a regular schedule. Usually, these coupon payments happen every six months. But bond ETFs hold many different issues at once, and at any given time, some bonds in the portfolio may be paying their coupon. As a result, bond ETFs usually pay interest monthly, rather than semiannually; the value of this payment can vary from month to month.

Bond ETF Advantages
Bond ETFs offer many advantages over single bonds:

• Diversification. With an ETF, you can own hundreds, even thousands, of bonds in an index at a purchase price significantly less than what it would be to invest in each issue individually. It’s institutional-style diversification at retail prices.
• Ease of trading. No more wading through the opaque OTC markets to haggle over prices. You can buy and sell bond ETFs from your regular brokerage account with the click of a button.
• Liquidity. Bond ETFs can be bought and sold at any time during the trading day, even in overseas or smaller markets where individual issues might trade much less frequently.
• Price transparency. With a bond ETF, there’s no more uncertainty over what your investment is worth: ETF prices are published publicly on the exchange and updated every 15 seconds during the trading day.
• More frequent income. Instead of coupon payments every six months, bond ETFs usually pay interest monthly. Though the value may vary from month to month, monthly payments give bond ETF investors a more regular income stream to use or reinvest.

Bond ETF Drawbacks
There are two main downsides to bond ETFs.

• You aren’t guaranteed to get your money back. Because bond ETFs never mature, they never offer the same protection for your initial investment the way that individual bonds can. In other words, you aren’t guaranteed to get your money back at some point in the future.

  However, some ETF providers have begun issuing ETFs with specific maturity dates, which hold each bond until they expire and distribute the proceeds once all bonds have matured. Invesco, for example, offers more than 20 investment-grade and high-yield corporate bond target-maturity-date ETFs under its BulletShares brand, with maturities at different years (2019, 2020 and so on); iShares similarly offers its own target-maturity-date bond ETFs.

• You can lose money if interest rates rise. Interest rates change over time. When they do, the value of bonds may fall, and selling those bonds can lead to losing money on your initial investment. With individual bonds, you mitigate the risk by just holding onto a bond until maturity, when you’ll be paid its full face value. Bond ETFs don’t mature, however, so there’s little you can do to avoid the sting of rising rates.

Bonds or Bond ETFs?
For most investors, buying individual bonds is out of the question. Even if it weren’t, bond ETFs offer diversity, liquidity and price transparency that single bonds can’t match, with the added benefits of intraday tradability and more frequent income payments. Bond ETFs do carry some additional risks, but all in all, they’re probably a better and more accessible option for the average investor.

Understanding VIX ETFs

The Cboe Volatility Index (VIX) attracts traders and investors because it often spikes way up when U.S. equity markets plunge. Known as the fear gauge, the VIX index reflects the market’s short-term outlook for stock price volatility as derived from options prices on the S&P 500.

The challenge is that investors just can’t access the VIX index. Period.

VIX ETFs exist, but they actually track VIX futures indexes, which creates two massive challenges:

1. VIX ETFs Don’t Reflect The VIX Index
By any measure, VIX futures indexes—and therefore VIX ETFs—do a lousy job emulating the VIX index. The VIX index is truly uninvestable, and over periods of a month or a year, the return pattern of VIX ETFs will differ radically from that of the VIX index.

2. VIX ETFs Tend To Lose Money—Lots Of It—In The Long Run
VIX ETFs are at the mercy of the VIX futures curve, which they rely upon for their exposure. Because the typical state of the curve is upsloping (in contango), VIX ETFs see their positions decay over time. Decay in their exposure leaves them with less money to roll into the next futures contract when the current one expires. The process then repeats itself, leading to massive double-digit losses over the course of a typical year. These funds almost always lose money long term.

In It for a Minute
In the real world, traders stay in VIX ETFs for one day, not one year. VIX ETFs are emphatically short-term tactical tools used by traders. Products like VXX are incredibly liquid, turning over their entire large AUM in one or two days of trading. Traders speculate with VIX ETFs because they offer the best (or least-worst) means to get at the VIX index in the very short run. So-called “short-term” VIX ETFs offer better one-day sensitivity to the VIX index then do “midterm” VIX ETFs.

Cboe Global Markets owns the VIX and is the parent company of ETF.com and ETF Report.

The Problem With Inverse/Leveraged ETFs

ETFs let investors express a vast number of viewpoints, including if an investor expects prices to fall, or wants to magnify a return.

Leveraged ETFs allow investors to take a chance to enhance the risk they’re taking on a daily basis, says Todd Rosenbluth, senior director of ETF and mutual fund research for CFRA. These funds often are designed to have returns two or three times their benchmark on a daily basis. Meanwhile, inverse ETFs allow investors to easily short an index if they believe the price will fall.

But the vehicles used to place these trades—leveraged and inverse ETFs—often have poor returns.

“They’re intended to move more aggressively than the broader market that they’re representing. If the trend flips, you can get hurt very quickly. You can make money very quickly, and it’s usually the getting hurt very quickly that investors tend to not see coming,” Rosenbluth said.

Daily Resets Erode Returns
The problem investors run into with these funds occurs when people hold them for more than a day or two, say Rosenbluth and Brett Manning, senior market analyst at Briefing.com.

Because they reset daily, arithmetic works against buy-and-hold investors, Manning says.

Manning used a hypothetical example to explain the long-term drag for leveraged performance. If an index on Monday is at 10, on Tuesday rises to 11 and on Wednesday falls back to 10, a double-leverage long ETF would rise to 12, but then fall to 9.82. It rose 20% on Tuesday, but fell 20% on Wednesday. Because a 20% drop from the higher number leads to a larger nominal decline, the investor loses money.

Conversely, in a double-leverage short using the same index, the investor’s ETF would fall to 8, but only rise to 9.46, because the rise is off a smaller number.

Even in range-bound markets, leveraged and inverse ETFs eat away at long-term returns because the moves are asymmetrical. Because the moves are magnified, the declines from higher levels are compounded, and the rebounds don’t get investors back to par because it takes more of a rally to make up the losses. So when prices drift around in range-bound markets investors usually don’t break even.

“With leveraged and inverse ETFs, when you make trades and how long you hold them is extremely important,” said Rosenbluth.

“Through November we had a slightly positive equity market but it was not a flat year. We had significant rallies and significant falls in the broader market, and particularly in the fourth quarter we’ve seen more volatility. If you’ve timed it well and have gotten out before the trend reversed itself, it’s likely it’s been a better year than the low single-digit returns of the S&P 500 indicated. But if you’ve stayed with these products as they’ve whipsawed back and forth, your returns are likely going to be different,” he added.

Market Directions Change Quickly
Some investors like to use leveraged/inverse ETFs when they see a market that has a strong directional trend, such as the drop in the oil market in late 2014 and early 2015. But that can be dangerous.

“You may have a thesis, but you have to be an expert in understanding price moves, and these are geared to a retail investor who doesn’t have a lot of time to formulate those ideas. If they get lucky, it’s like winning the lottery. But if you don’t get out in time, you can quickly lose gains,” Manning said.

Rosenbluth and Manning say these ETFs are really designed more for frequent trading, or to try and time the market.

“They can serve a purpose, but they can also be something that causes investors to lose money faster than they anticipated,” Rosenbluth said.