Lesson 12: ETFs

Lesson 12: ETFs

Mutual funds ETF Headingare great, but they have some drawbacks.  If you want to sell it, you have to wait to the end of the day. In addition mutual funds have some unavoidable costs and some limited functionality. In response to these shortcomings Exchange Traded Funds (ETFs) were created about 20 years ago and are one of the most recent and interesting financial innovations of the present day.

Key Points

  • An ETF is a type of hybrid investment company.
  • Creation is the process by which an ETF is created.
  • Redemption can be thought of as the reversal process of creation.
  • ETFs possess cost and functionality benefits compared to mutual funds.

What is an ETF?

An Exchange Traded Fund is a special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.  The investor receives profits on the assets owned (interest if bonds are tracked or dividends if stocks) on a pro rata share basis.  The easiest way to describe an ETF is to think of it simply as a mutual fund with some increased functions (if a mutual fund is a knife, an ETF is a Swiss army knife).   One of the most crucial differences between an ETF and a mutual fund relates to the method of trading.

As you may remember a mutual fund is priced once a day at the end of trading. Thus buy and sell orders are processed at the price (Net Asset Value) at the end of the day for mutual funds. This is not the case for ETF shares. You can trade ETF shares at any point during the day on an exchange.  To understand what makes an ETF valuable and why it has key benefits over a mutual fund, we first must see how these funds are constructed.

How is an ETF Constructed?

Two crucial processes in ETF functionality are construction and redemption. Let’s begin by analyzing construction, which as the name suggests is how an ETF is created.

Let’s assume that I want to create an ETF (Colby Duhon Superfund).  Thus the Colby Duhon Superfund is the sponsor of the ETF. My first decision is what asset do I want to track.  Tracking means I will possess this asset whose value can fluctuate.  My choices include indexes like the S&P 500, bonds, gold, etc.  For the sake of this example let’s assume the Superfund will track the S&P 500.  The problem is the Superfund does not have enough capital (money) to purchase all the stocks traded in the S&P 500. This creates the role of the Authorized Participant.

The Authorized Participant (AP) is a large market maker or financial institution with sufficient buying power to provide the ETF with the asset it desires. Basically the Authorized Participant is the rich relative who has the buying power to purchase the assets the sponsor wants to package up as a unit.  It is worth noting that in some cases the sponsor and AP can be the same entity.  For the sake of the Superfund example we will assume this is not the case.

Now that the AP knows that the Superfund wants to track the S&P 500, it will go out into the market and buy the shares that comprise the S&P 500 in the proportion that the shares make up the index.  Once the AP has the shares assembled, it now has a basket of securities.  The AP will then trade this basket of securities to the sponsor (Superfund) and in exchange receive a creation unit which usually represents 50,000 shares of the ETF.  The AP then sells the shares of the creation unit in the open market.  When you buy a share of an ETF, you are buying a piece of this creation unit.

Old Guy in Chair
“Back in my day we didn’t have cool widgets.” Image courtesy of bbc.com

An easy way to think about this is continuing with the rich relative metaphor. You (the sponsor) want to create a cool widget that would sell well but you need some parts to make it. You contact your rich uncle (AP) and ask him to buy all the parts in the market.  The rich uncle buys the parts (stocks) and gives them to you. You assemble the new widgets using the parts and in exchange for the parts give your uncle the widgets (creation unit). Your uncle now has cool widgets to sell while you keep the parts.

As a final note in our example we created an ETF that tracked the S&P 500. We could create an ETF that tracks other assets such as bonds or gold. In any case the process is similar with the AP purchasing the assets (bonds or gold) and the sponsor providing the creation unit to the AP to sell.

ETF Creation Diagram
ETF Creation Process

 

Redemption

Redemption can be thought of as the opposite of creation. In creation the AP gave the basket of assets to the sponsor and received the creation unit of shares. In redemption the AP returns the creation unit to the sponsor and receives the basic of assets back.

As I said before an ETF has many similarities to a mutual fund. So if presented with a mutual fund that tracks a market index and an ETF that does the same why would I choose the ETF? 1. Cost benefits 2. Functionality benefits.

Cost Benefit of ETF vs. Mutual Funds

  1. Cheaper operational fees: Due to the unique structure of the ETF, the ETF fund charges lower operational costs compared to that of a mutual fund. The difference lies in the presence of the AP when investing in an ETF. Due to this “middle man” the investing process is greatly simplified for the ETF fund and investor and this simplification translates into cost savings for the investor. For a direct comparison the average U.S. Equity Fund charges 1.46% in annual expenses where the average ETF Equity Fund charges 0.53%.1
  2. Favorable tax treatment: Most ETFs incur very few capital gains tax due to their unique creation process. ETFs and mutual funds are required to distribute capital gains to their investors, which will be subject to capital gain tax. Ouch. An ETF is able to avoid this problem by having a very low turnover ratio and avoiding the presence of a sale in the redemption process. The avoidance of a sale matters because if the ETF had to sell the shares it had to raise cash, this would be taxed. However a quick review of the redemption process reveals that when the ETF needs to raise more cash it does not “sell” the assets, but trades them to the AP for the equivalent creation unit. This structure enables ETFs to avoid unfavorable taxes.

Functionality Benefits of ETF vs. Mutual Funds

  1. Intraday Trading: As previously mentioned one of the crucial differences between an ETF and mutual fund is the ETF’s ability to trade intraday. Not having to wait till the end of the trading day could make a huge difference on your strategy in addition to being a nice convenience feature.
  2. The presence of options and other features: Though I haven’t discussed them yet, an ETF gets added functionality from the ability to purchase options on them. Options briefly are a form of derivative security that enables you the investor to buy or sell an underlying security for a set price.  What is necessary to understand is based on the presence of these, ETFs obtain a dimension of functionality unmatched by mutual funds.

 

Definitions

  1. Exchange Traded Fund (ETF): A special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.
  2. Creation: The process of creating an ETF or more specifically creating a creation unit whose shares will be traded on the open market.
  3. Creation unit: A block of shares (usually 50,000 shares) created by the ETF and whose individual shares are sold on the market.
  4. Redemption: The process of trading a creation unit for the underlying assets it represents.
  5. Sponsor: An entity that wishes to create an ETF.
  6. Authorized Participant (AP): A market maker or large financial institution that possesses the capital needed to purchase the underlying assets a sponsor wishes to transform into an ETF.

 

Further Reading

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