Understanding ETF Basics

The difference between mutual funds and exchange-traded funds is a thing of beauty.

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Reviewed by: Heather Bell
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Edited by: Heather Bell

[This article appears in our January 2021 issue of ETF Report.]

 

E-T-F: The three letters are becoming more ubiquitous in the financial press, but it’s clear that not all investors know they stand for “exchange-traded fund. ” ETFs are, essentially, funds that trade on financial exchanges like stocks.
The most important thing to understand about ETFs is that, legally, they’re considered mutual funds. The only difference is that ETFs trade on an exchange, meaning you can trade in and out anytime during market hours.

On the other hand, mutual funds have been around for about a century. Before ETFs became an offshoot of them nearly 30 years ago, mutual funds were the most accessible way for the average investor to hold a large basket of stocks.

Essentially, a mutual fund allows a group of investors to hold a basket of stocks in common, with shares representing the proportion of the basket that each investor owns. The mutual fund tallies up the value of everything it owns and divides it by the number of shares that exist at the end of each business day to arrive at the net asset value (NAV). Thus, the investors know how much their holdings are worth on any given day.

ETFs take the mutual fund concept and amp up its advantages. For one thing, you can trade an ETF throughout the day, so if the market takes a turn you don’t like, you don’t have to wait until market close to get out of a fund. You know exactly how your fund is performing throughout the day, just as you would an individual stock. And similar to a stock, you can short an ETF, write options against it or buy it on margin.

Creations, Redemptions & APs
One of the great benefits of the ETF is its creation/redemption mechanism and the authorized participants that drive it.

An authorized participant is generally an institution like a large investment bank. Their job is to make sure that ETFs trade at or close to their NAV. To do this when a large spread between the NAV and trading price opens up, they arbitrage shares through the creation/redemption process as necessary until the ETF’s share price is brought back into alignment with its NAV. APs trade in large blocks of shares in the area of a minimum of 50,000.

Creations and redemptions take place on the primary market for the ETF. To create shares in the case of a premium developing—meaning the price is higher than the NAV—an AP will buy the securities in an ETF to create and sell shares of the fund that can be sold on the secondary market (the stock exchange) to meet demand until the premium is closed up.

When a discount develops, where the price is below the NAV, the AP will buy shares of the ETF to remove them from the secondary market so that the supply more closely matches the demand (or lack thereof) and the discount eventually closes up. The securities underlying those shares can be redeemed from the fund for market value, and the AP can sell them.

In this way, an ETF’s liquidity can be maintained and is largely unconnected to the liquidity of its underlying holdings. But that’s not the only purpose of the creation/redemption mechanism. It also has significant tax implications.

Tax Benefits
The creation/redemption mechanism is the source of ETFs’ tax efficiency. A mutual fund that sells a security for any reason will incur a capital gain and the tax consequences that come with that. Security sales can happen for a host of reasons: rebalancing, redemptions by shareholders or just ordinary portfolio adjustments. Capital gains are paid out to investors on an annual basis under the laws governing mutual funds.

However, ETFs have a way around these inconvenient profits. First of all, since the vast majority of them are passively managed, ETFs tend to be very disciplined with regard to trading, generally only executing trades according to the demands of the index, some of which only rebalance annually. ETFs just have fewer occasions to incur capital gains.

Secondly, and most importantly, ETFs can use the creation/redemption mechanism to sidestep a sizable percentage of the capital gains that they’d incur if they were traditional mutual funds.

When a mutual fund investor wants to cash out of the fund they’re invested in, the fund has to sell the securities to meet that redemption, and those costs are spread out across the mutual fund’s investor base.

But an ETF investor just needs to sell their shares of the fund on an exchange and deal with capital gains on their own. The fund itself never sees any consequences from the transaction, nor do its remaining shareholders.

It gets even better when an AP redeems shares of an ETF. In that case, the AP receives the stocks underlying the shares of the ETFs—an “in kind” transaction. With no formal sale, there are no resulting capital gains incurred.

The ETF issuer can even pick and choose which shares to give to the AP—meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.

Explaining ETNs
While true ETFs are just a type of open-ended mutual fund, there are a several structures that can fall under the ETF rubric, such as grantor trusts and commodity pools. But the most common of these alternate structures is the exchange-traded note.

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, with long-term capital gains coming with a tax of 20%, less than the long-term cap gains tax burden for grantor trusts or limited partnerships.

The downside of an ETN is that if the underlying bank goes bankrupt, you lose essentially all of your money; for instance, there were 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 fairly minor. Institutional investors can “redeem” (get their money back) from the underwriter of an ETN on a daily basis. While anything can happen, you can usually see major bank defaults coming more than a day or two ahead of time.

Keep in mind that ETNs are more complicated than ETFs, and as debt instruments, the motivations for shutting them down can be more complicated. If a bank is looking to clear up the debts on its books, a large ETN might be doomed to closure despite being widely used by investors, which we’ve seen over the years. ETNs can be very suitable investments for some, but it’s even more important than it is for ETFs that prospective ETN investors read the fine print associated with the product they’re looking at.

Bond ETFs
Bond ETFs require more explanation than equity ETFs, simply because bonds are more complicated than stocks. As over-the-counter products, they tend to be thinly traded, with some not trading at all for weeks or even months, and their prices can become stale or just plain out-of-whack relative to their actual value.

However, ETFs can allow investors to circumvent that. Just because the underlying securities of a bond ETF aren’t being traded doesn’t mean nobody’s trading the ETF that holds them. In this way, bond ETFs can provide price discovery for the bond market.

With regard to dividends, while most bonds pay out their dividends semiannually, most bond ETFs pay out dividends on a monthly basis since they’re holding so many bonds, all with different distribution schedules. This can be useful for investors seeking monthly income, even if the amounts of the payouts can vary from month to month.

One of the drawbacks—or perhaps simply “unbondlike” features—of a bond ETF is the fact that the bond ETF never matures. It’s a basket that rotates out its holdings as they mature and buys new ETFs.

This means traditional bond strategies like laddering aren’t that easily done with ETFs. However, the ever-innovative ETF industry has found a way around this.

Multiple firms have launched “target maturity” bond ETFs that hold bonds that mature in the same year. Once all the holdings of the fund have reached their maturity, the fund ceases to trade and is pulled from the market, usually to be replaced by a fund maturing at a later date.
Such ETFs are suitable for investors looking to implement laddering strategies, but also for investors looking to cash out on a specific date for a particular purpose, like paying for a child’s college tuition, or buying a retirement home.


PROS Of ETFs

  • Intraday Liquidity: You can buy and sell ETFs at any time during the trading day. If the market is falling apart, you can get out at
    10 a.m. In a mutual fund, you would have to wait until after the close of trading … which could be a costly delay.
  • Lower Costs: Although it’s not guaranteed, ETFs often have lower total expense ratios than competing mutual funds. The reason is simple: When you buy shares of a mutual fund directly from the mutual fund company, that company must handle myriad paperwork to record who you are, where you live and to send you documents. When you buy shares of an ETF, you do so through your brokerage account, and all the record keeping is done (and paid for) by your brokerage firm. Less paperwork equals lower costs, most of the time.
  • Transparency:  Holdings of most ETFs are disclosed on a regular, frequent basis, so investors know what they’re investing in and where their money is parked. Mutual funds, by contrast, only disclose their holdings quarterly, with a 30-day lag.
  • Tax Efficiency: ETFs are almost always more tax efficient than mutual funds because of the benefits of their creation/redemption mechanism.
  • Greater Flexibility: Because ETFs are traded like stocks, you can do things with them you can’t do with mutual funds, including writing options against them, shorting them and buying them on margin.

Cons Of ETFs

  • Commissions: The beauty of intraday liquidity doesn’t come without costs: Typically, you pay a commission when you buy or sell any security, and ETFs are no different, which can make dollar cost averaging cost-prohibitive. There are an increasing number of commission-free ETF trading programs in place at firms like Charles Schwab, Etrade, Fidelity and TD Ameritrade. But check before you trade.
  • Spreads: In addition to commissions, investors also pay the “spread” when buying or selling ETFs. The spread is the difference between the price you pay to acquire a security and the price at which you can sell it. The larger the spread—and for some ETFs, the spread can be quite large—the larger the cost. There’s  no way to avoid this.
  • Premiums & Discounts: When you buy or sell a mutual fund at the end of the day, you always transact exactly at its stated “net asset value” (NAV), so you always get a “fair” price. While mechanisms exist that keep ETF share prices in line with their fair value, those mechanisms aren’t perfect. At any given moment, an ETF might trade at a premium or a discount to its NAV. If you buy at a premium and sell at a discount, ouch … you’ve lost out.
  • General Illiquidity: Not all ETFs are as tradable as you think. Some trade rarely, or only at wide spreads, which can make them hard to unload once you purchase them.

Heather Bell is a former managing editor of etf.com. She has also held editorial positions at Dow Jones Indexes and Lehman Brothers. Bell is a graduate of Dartmouth college and resides in the Denver area with her two dogs.