ETFs, a component of a broader category of “exchange-traded products,” are (almost wholly) passive pooled investment vehicles made up of securities that track a basket of securities like an index, or a commodity, bonds, or other types of assets, which investors can buy and sell on a stock exchange (like stocks) throughout the day at a market-determined price.
Like mutual funds, ETFs are pooled investments offering investors a convenient means of diversification with a single investment (favorable due to its decreased risk). The biggest difference of ETFs is that they’re traded on an exchange.
Passive vs Actively Managed ETFs
For the first 15 years following the first U.S. ETF company’s Securities and Exchange Commission (SEC) approval in 1993, ETFs were exclusively passive investment vehicles. But in 2008, the SEC approved the usage of actively managed ETFs.
Like a typical ETF, actively managed ETFs they have a high level of transparency (see “Transparency of ETFs” below), publicly disclosing their portfolio holdings on a daily basis. Their key difference is that rather than simply tracking an index, an investment advisor actively curates the fund’s portfolio of stocks, bonds, and other assets based on its stated investment objective.
But they’re rare. In 2015, nearly $28 billion of the $2.1 trillion total assets invested in ETFs were held in the active kind, or around just 1%. In terms of individual fund numbers, in 2015 there were 134 actively managed ETFs, of 1594 total in the U.S. per the Investment Company Institute. Given their rarity, we’ll leave them out of the discussion.
Common Types of ETFs
ETFs funds types vary according to their principal investments. The main types are:
- Money market funds – These invest in short-term fixed-income securities.
- Fixed-income funds – These invest in bonds and tend to have higher yields than money market funds and lower volatility than equity funds.
- Equity funds – These invest in stocks, which are a riskier investment than fixed-income and money market funds.
- Hybrid funds – Also known as target-date funds and asset allocation funds, these invest in both bonds and stocks, or in ‘convertible securities’, which (as you can probably guess) can be converted to other types.
- International funds – These refer to funds that invest in companies outside of the investor’s home country. They add diversification to a U.S.- (or wherever you are located) based portfolio.
- Global funds – Not to be confused with international funds, global funds are those that invest in companies anywhere in the world, including the investor’s home country.
- Sector and specialty funds – These focus in on a specific industry, e.g., gold, real estate, energy, or health care. They hold a higher risk due to their concentrated scope.
Here are the most common forms ETFs take.
Exchange traded open-end fund – In open-end ETFs, which comprise the vast majority of ETFs, dividends are reinvested upon the day of receipt and disbursed to shareholders in cash quarterly. Securities lending is allowed, and derivatives (contracts between two parties that specifies conditions under which payments are made between them) are used.
Exchange-traded unit investment trust (UIT) – In UIT ETFs, dividends cannot be reinvested. There is no securities lending or derivative usage.
Exchange-traded grantor trust – Grantor trust ETFs are typically those that hold a physical asset (such as precious metals and currencies). Investors in these types of ETFs are direct shareholders of the underlying assets, and thus are taxed as though they are direct owners of the asset.
Limited partnership – Like grantor trusts ETFs, limited partnership ETFs also focus on commodities.
How Are ETFs Formed? What is the Creation/Redemption Process?
The formation and creation/redemption process of an ETF is somewhat complicated, but worth taking some time to understand.
ETF Creation Process
Here are the steps in the formation of an ETF.
1. When a prospective ETF manager or “sponsor” seeks to create an ETF, they file the required regulatory materials with the SEC.
2. Upon the ETF’s approval, the sponsor designates an authorized participant (AP), an entity tasked with acquiring the underlying assets needed for the ETF and who is empowered to create and redeem its shares. APs are usually large institutional investors (groups that pool money to make significant investments) such as market makers (broker-dealer firms that facilitate the trading of securities). Sometimes the sponsor also functions as the AP.
3. The AP purchases shares of the asset type (equities [stocks], fixed income [bonds], commodities, etc.) the ETF company desires to hold (often from a pension fund), in the same proportions as the relevant underlying index or collection of securities.
4. It then places those shares into a trust with a custodial bank (a financial institution specifically responsible for safeguarding a firm’s or individual’s assets, and which doesn’t engage in commercial or retail/consumer banking).
5. The custodial bank forms blocks of shares, termed “creation units.” Creation units often contain 50,000 shares, but they can range between 10,000 and 600,000.
6. The trust provides blocks of equally valued ETF shares—legal claims to the shares held in the trust—to the AP. They are priced at their NAV rather than their market price, making profit.
7. The AP then sells those shares on the open market. While the ETF’s shares are then traded in the secondary market, the ETF’s underlying securities borrowed for the formation of creation units remain in the trust, which trust pays the ETF sponsor dividends and oversees administration.
It’s a win-win for both parties: While the ETF sponsor obtains the stocks needed to track the index, the AP gets a trove of shares to resell for profit. It’s a fair-value, one-to-one trade, with the ETF shares that are given to the AP priced at their NAV rather than their market price.
Also, because it’s an in-kind trade, taxes are not incurred at any stage in the creation process.
ETF Redemption Process
The redemption process of ETFs may take a couple different routes.
Retail investors, or individual investors who purchase securities for their own account (also called small investors), generally opt to sell their shares in the secondary market (stock exchange).
The AP or other institutional investors (or retail investors with the means to buy large volumes of shares) can facilitate removal of ETF shares from the open market by purchasing enough to form a creation unit and delivering them to the ETF sponsor, in exchange receiving the equivalent value in the fund’s underlying securities. In this case, the ETF can minimize its tax liability by choosing its shares with the lowest potential of capital gains taxation (see “Taxation of ETFs” below for details).
How Are ETFs Traded?
Retail investors (everyday investors who buy securities for their own personal accounts, as opposed to institutional investors, which generally buy securities in larger quantities) purchase ETFs on a secondary market (that is, a stock exchange) through a broker, investment advisor, or online trading platform. ETFs don’t sell individual shares to investors. Market makers, known as “authorized participants,” issue them in bundles of shares called “creation units.” Generally, investors purchase creation units with a basket of securities similar to the ETF’s portfolio, rather than with cash. Subsequently, investors split up their creation units and sell the individual shares within them on a secondary market. Or, they can sell the creation units back to the ETF.
The ability to perform intraday trading of ETFs makes them more liquid than mutual funds.
Note also that ETFs trades take a few days to close, which may be a downside for some investors.
How Are ETFs Priced?
Net asset value (NAV) is the per-share value of a mutual fund or ETF, and is based on the total value of assets (including stocks, bonds, cash, and other securities) in its portfolio less any liabilities (such as the manager’s salary and operating expenses) it may have, the total of which is divided the number of shares outstanding (the total amount of shares being held by shareholders). It provides a good picture of a fund’s per-share fair market price.
Exchange-traded funds’ NAV is updated once per day following the closure of markets at 4:00 p.m. ET, and an expected NAV (called the intraday NAV [iNAV], the intraday indicative value (IIV), or intraday operative value [IOPV]) is calculated every 15 seconds.
Like stocks, ETF’s prices (their market price) fluctuate throughout market day; investors can buy and sell at a premium (for a cost higher than the NAV) or at a discount (for a cost less than the NAV). This deviation from the NAV is known as the bid-ask spread. The bid-ask spread is the amount by which the ask price (the market price at which investors are willing to sell securities) exceeds the bid price (the market price at which investors are willing to purchase securities). For retail investors, it’s usually under a nickel per share. Bid-ask spreads are more prominent in the case of thinly-traded/low-volume securities, while more inconsequential in the case of highly liquid securities (those whose price is resilient to the effects of buying and selling) because buyers and sellers are in greater agreement over what prices should be. By contrast, bid/ask spreads are inapplicable in the case of mutual funds since they are only priced once a day (after the market closes) and trade at the net asset value, meaning there is no fluctuation in price throughout the trading day.
ETFs’ creation/redemption mechanism prevents ETF share market prices (the price their shares are sold for on the market) to stray too far from their NAVs, and thus generally keeps bid-asks spreads to a minimum. When there is a large discrepancy, the ETFs’ APs effectively regulate it through arbitrage, the profit-driven simultaneous purchasing and selling in multiple markets of securities with price mismatches between their NAV and market value. It entails buying securities at a discount (less than NAV) to resell at a premium (more than the NAV). APs are privileged in that they can purchase shares of ETFs at their NAV. When investor demand for ETF shares is high and their price is thus driven up past their NAV, the APs buys the ETF’s underlying shares and resells them at a profit on the open market, causing the price to come down due to the increase in supply. On the other hand, when demand is low and ETF share prices fall below the NAV, APs can purchase 50,000 shares cheaply and resell them for the underlying securities to resell at a profit.
Unlike mutual funds, ETFs generally don’t charge 12b-1 fees (which cover marketing/distribution costs and a service fee) since less marketing is involved, as is an inherent feature of passively managed funds. They also lack load fees, sales charges or commissions charged to investors when they buy and sell securities as a percentage of the investment.
However, there are several types of costs associated with ETFs to consider: brokerage commissions, the expense ratio, bid-ask spread, and redemption fees.
Brokerage fees – Since retail investors have to buy ETF shares through brokerage companies, they typically pay brokerage commissions. They can be a flat fee or can be based upon the investor’s total assets held in their account. But not all ETF providers charge commission fees—Vanguard, for instance, is one such provider.
Expense ratio – An expense ratio is a measure of a mutual fund company’s operating costs and is calculated by dividing its operating expenses by the average value of its assets under management (AUM), calculated on a yearly basis. ETFs’ expense ratios are relatively low since they’re mostly passively managed. According to Vanguard, the industry average ETF expense ratio is 0.53%, while Vanguard’s is 77% lower, at 0.12%.
Bid-ask spread – As mentioned earlier, bid-ask spread is a feature of ETFs. Wider spreads means higher costs of trading.
Redemption fees – Redemption fees may be charged if ETFs are held for less than a specified duration, like 30 days.
Investment Minimums and Costs of Purchasing an ETF
ETFs are relatively accessible options for those without a lot of capital to invest, as they can be purchased for the price of a single share. How much does an ETF share cost? As one example, top ETF provider Vanguard’s 13 international ETFs range from about $40 to $100, while their 17 stock ETFs range from about $70 to $220 (view all of their ETF options here).
Taxation of ETFs
Capital gains (that is, profit from stocks) are calculated by subtracting the “cost basis” (or “tax basis”), the amount a stock was purchased for, from the amount a stock was sold for. The short-term capital gains tax rate, which applies to securities held onto for one year or less, is simply the ordinary income tax rate. For securities held onto for 366 days or more, long-term capital gains tax rate applies and is significantly lower, particularly for those in the upper and lower tax brackets.
Both mutual funds and ETFs require tax payment on capital gains and dividend income.
However, the creation and redemption process for ETFs is such that ETFs are more tax efficient.
When an investor wants to redeem ETF shares, they transact directly with other investors, independently from the ETF. Thus, the tax implications of selling shares are felt only by those doing the selling. By contrast, when investors redeem shares of a mutual fund, the fund sells securities to raise cash and meet the redemption, incurring capital gains taxes.
Those capital gains taxes are distributed equally among fund holders.
With ETFs taxes are usually incurred only at two points: upon receiving a dividend and upon selling the entire investment.
Due to the passive construction of most ETFs, there is little turnover; less buying and selling translates to less opportunities for capital gains to be charged.
Because of ETFs’ “in-kind redemption” feature, no or a negligible amount of taxes is incurred until the ETF holder sells the fund.
Further, when an AP seeks to redeem shares with an ETF, the fund normally doesn’t sell securities to pay them with cash. Instead, it provides them with the ETF’s actual underlying securities, selecting shares that were purchased at the lowest possible cost basis in order to minimize the potential for capital gains taxation later.
Fixed-income (bond) ETFs are an exception, as they often have high turnover and cash-based creation and redemptions.
Transparency of ETFs
ETFs have the benefit of transparency on their side. ETFs disclose their portfolio holdings on a daily basis, available at no cost to the public. By contrast, mutual funds are only required by the Securities and Exchange Commission (SEC) to report their portfolio at the end of each fiscal quarter.