Ferri: ETF Does Not Mean Index Fund

January 21, 2014

It wasn't always so, but don't confuse an exchange-traded fund with an index fund, Rick Ferri says.

Exchange-traded funds (ETFs) started out linked at the hip to low-cost, market-tracking index funds. The only ETFs available during the 1990s were those that followed well-known benchmarks such as the S&P 500 (SPY) and the Nasdaq 100 (QQQQ). That’s no longer the case.

Today, the ETF acronym is being used broadly by the fund industry and media outlets to include non-fund product structures and active management strategies. This usage has created confusion in the marketplace and isn’t healthy, in my opinion. It’s like saying the Dow Jones Industrial Average is the stock market.

The exchange-traded product (ETP) marketplace has evolved since the 1990s. Most ETPs are classified as ETFs, meaning they follow an Investment Company Act of 1940 structure. However, several other non-fund ETP structures have been created, and they too are lumped under the ETF acronym. This makes for investor confusion.

The ETF acronym has become a catchall by the industry and the media for any exchange-traded product that has a creation and redemption feature. This operational process allows for the number of shares outstanding of a product to change during a trading day depending on supply and demand needs.

The creation and redemption feature makes ETPs distinctly different from closed-end funds (CEFs). CEFs have a fixed number of shares outstanding, which can lead to large discounts and premiums in market pricing relative to net asset value (NAV). The ability to create and redeem ETP shares intraday significantly reduces the spread between market price and NAV.

There are several types of exchange-traded products available to investors. They include exchange-traded notes (ETNs), grantor trusts, limited partnerships and 1940 Act funds (ETFs). Each structure has different underlying features, operational challenges, regulatory controls, and the tax treatment for income distributions and capital gains are different.

Vanguard has recently published a guide to help sort ETP differences. ETF structures at-a-glance is a handy reference piece that summarizes the key regulatory and tax features of each structure. You can find detailed analysis of each structure in The ETF Book.

I think it’s noteworthy that Vanguard is labeling all ETP structures as ETFs in the title of its guide. That’s not correct, but neither is the whole ETF acronym situation. Vanguard’s just trying to get people to use their guide.

Most assets in ETFs are tracking capitalization-weighted market indexes. These are familiar indexes that we’re all familiar with. ETFs that track market benchmarks have significantly more assets in them than ETFs that employ other strategies, and continue to attract most of the new asset flow according to Morningstar. The S&P 500 is the largest and most popular index in this category.

 

 

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