Field Guide to Exchange-traded Funds (ETFs)

By Randall Rohn
Analyst, mPower

In This Story ETF Pros and Cons The Premium/Discount Dynamic The Case for Greater Tax Efficiency Are They Really Less Expensive?

Amid a flurry of new offerings and burgeoning investor interest, exchange-traded funds, or ETFs, have been much discussed in the financial press lately. In the third quarter alone, ETFs attracted $5.6 billion in inflows, according to a study by New York–based research firm Strategic Insight.

Given the explosion of interest in these funds, now is a good time to take a closer look at them.

minute: read this article at a glance.

Technical Terms Net asset value (NAV) Index fund Arbitrage Brokerage window Bid-ask spread

What exactly is an exchange-traded fund (ETF)? An ETF is essentially a fund that tracks a market index or sector and trades throughout the day on a stock exchange. Traditional index funds have the same goal, but they can't be traded in real time — they trade according to their net asset value (NAV), which is only calculated at the end of the trading day.

Barclays Global Investors has led the way in the recent proliferation of these funds with the addition of over 40 new funds to its menu of ETFs earlier this year, and index-fund giant Vanguard Group has announced plans to introduce ETFs of its own.

Given all of the attention currently surrounding ETFs, you might assume that these products are relatively new to the marketplace. In fact, ETFs have been around for several years. The American Stock Exchange launched Standard & Poor's Depositary Receipts (SPDRs), known as "Spiders" and trading under the ticker SPY, in 1993. SPY is the largest ETF, according to Strategic Insight. The Amex is also behind three other top ETFs: the NASDAQ-100 (ticker: QQQ), Standard & Poor's MidCap SPDRs (ticker: MDY), and Dow Industrials DIAMONDS (ticker: DIA).

ETF Pros and Cons

Fund strategists and financial journalists — not to mention the firms sponsoring the funds — have lauded ETFs as superior alternatives to traditional index funds.

But there have been vocal criticisms of the ETF phenomenon as well. Mercer Bullard, former SEC regulator and founder of investor-advocacy firm Fund Democracy L.L.C., claims that ETFs expose investors to unknown risks due primarily to inadequate representation by ETF sponsors and by the Amex, where the majority of the funds are traded.

Aside from the fact that ETFs can be traded intra-day, their alleged superiority to traditional mutual funds rests primarily on the premise that ETFs are less expensive and more tax-efficient. The chief argument against them revolves around the capacity of these funds to trade at discounts or premiums to their NAV — in other words, the net value of the underlying stocks in the fund's portfolio. The following discussion investigates each of these claims in an effort to determine whether ETFs can be attractive alternatives for a diversified portfolio.

The Premium/Discount Dynamic

One of the most common criticisms surrounding ETFs is the propensity for the funds to trade at a premium or a discount to their underlying NAV. The worry is that, because ETFs trade continuously during market hours, investors may lose money by buying ETFs at a premium and subsequently selling their shares at a discount.

One of the most common criticisms surrounding ETFs is the propensity for the funds to trade at a premium or a discount to their underlying NAV.

The originators of ETFs were acutely aware of the discount/premium issue. In an effort to keep the prices of ETFs in line with NAV, ETFs utilize something known as a creation unit.

Here's how it works. The creation unit consists of a basket of stocks that mirrors the index that the particular fund is designed to track. Institutions and large investment houses assemble the creation units, which typically consist of $5 million to $10 million worth of equity. They then swap the units for shares in the ETF, which they sell to the investing public at the retail level. The institutions, however, reserve the right to convert these retail ETF shares back into creation units at their discretion.

In this way, the intra-day prices of ETFs are generally kept relatively close to the fund's NAV. The convertibility of the creation units and the retail shares acts as a kind of arbitrage.

To illustrate, suppose an ETF is trading at a premium to its NAV. The institutions that put together the creation units could exchange them for ETF shares, which they could then sell at a profit. Similarly, should an ETF be trading at a discount to its underlying NAV, the same institutions could buy the retail ETF shares, exchange them for creation units, and then proceed to sell the component securities at a profit. Such arbitrage activity is an efficient method of mitigating the discount/premium problem. Granted, such a strategy is far less effective when the underlying securities are small and/or thinly traded. The majority of ETFs, however, track major market benchmarks whose component stocks are large, liquid and efficiently traded.

The Case for Greater Tax Efficiency

ETFs are frequently heralded as more tax-friendly than traditional mutual funds. This claim especially resonates with shareholders in the throng of mutual funds that have already made large capital gains distributions this year. Such distributions can result in hefty tax bills, and there are likely to be many more such payouts in the closing months of 2000.

One drawback of conventional mutual funds is that investors are often hit with capital gains taxes even when they don't sell any shares. Portfolio managers of these funds may be forced to sell securities to meet shareholder redemptions — that is, to pay for shares investors are selling back to them — thus triggering taxable gains that must be passed on to the remaining fund shareholders. Long-term investors are the victims.

An obvious benefit of ETFs is that managers are not forced to sell securities in response to shareholder redemptions. Thus, the buy-and-hold investor is not hit with involuntary capital gains bills. While this enhances the tax efficiency of ETFs, it does not mean — as many investors believe — that these funds do not distribute any capital gains to shareholders. They do.

An obvious benefit of ETFs is that managers are not forced to sell securities in response to shareholder redemptions. Thus, the buy-and-hold investor is not hit with involuntary capital gains bills.

Certain ETFs have made regular capital gains distributions in line with their mutual fund contemporaries. A good example is the Standard & Poor's MidCap 400 Depositary Receipts Trust, which has realized a capital gains distribution every year since its 1995 inception.

Nevertheless, the alleged greater tax efficiency is one of the stronger claims of ETFs over customary mutual funds. The reasoning goes beyond the advantage of not having to redeem shares in response to the activity of individual investors, thus triggering taxable capital gains for mutual fund shareholders. It goes back to the financial institutions that convert and exchange retail shares for creation units, and vice versa. Such exchanges are made "in-kind," meaning that the ETF shares are exchanged for the basket of stocks (that is, the creation units) that tracks the underlying index. Why is this important? Because these in-kind transactions are not taxable events. Therefore, the lowest cost shares — the shares that stand to realize the largest capital gains — may be unloaded each time such a transaction takes place. The outcome should be smaller capital gains distributions and a lower tax bill.

Although money held in a 401(k) or other tax-deferred account is not subject to capital gains taxes, the greater tax efficiency of ETFs may make them an appealing alternative to traditional index funds in the taxable portion of a retirement portfolio. Most 401(k) plans offer an option to invest in a regular index fund; ETFs are generally only an option for those plans that allow investment through a brokerage window.

Are They Really Less Expensive?

ETFs are regularly touted as being less-expensive alternatives to investing in traditional index funds. In general, this appears to be the case. For example, Barclays Global Investors recently introduced a bevy of new ETFs. Seven of these funds track indexes also tracked by traditional mutual funds offered by Vanguard Group. Wall Street Journal columnist Jonathan Clements published a column this summer in which he compared the expenses of each of the seven traditional mutual funds with those of the Barclays ETFs. He reports that in two instances the annual expenses were identical. However, the Barclays offerings were cheaper in the other five cases, typically by 4 basis points to 5 basis points.

All other things being equal, given two identical funds, the less-expensive alternative is always superior. But all other things are rarely equal. As Clements points out, the difference in annual expenses he found between the traditional index funds and the ETFs amounts to 4 cents to 5 cents per annum per $100 of the investment. While it's always prudent to seek low-cost investments, savings on this scale is probably not sufficient reason to sell your mutual funds in favor of ETFs.

Determining whether ETFs are truly less expensive than traditional funds necessitates looking beyond their annual expenses.

To measure the total cost associated with ETFs, one should take note that part of their appeal is the fact that they can be bought and sold throughout the trading day. Preliminary statistics suggest that investors are taking full advantage of that ability. To wit, the same Wall Street Journal column cited above reported that through the first five months of the year, the average holding period for Standard & Poor's Depositary Receipts (SPDRs) was just 19 days. The average for the popular NASDAQ-100 Index Tracking Stock over the same period was an astonishing four days. Every time an investor buys or sells ETFs, he or she incurs brokerage fees and other costs associated with trading. The advantages of lower costs and greater tax efficiency that ETFs exhibit over traditional mutual funds are relinquished through active and excessive trading. The accumulated brokerage fees and short-term taxable gains realized from such trading more than counter these advantages.

The average holding period for the popular NASDAQ-100 Index Tracking Stock through the first five months of 2000 was an astonishing four days.

Additionally, conventional mutual funds can generally be bought and sold at NAV, while investors in ETFs must be mindful of the bid-ask spread. This spread is the difference at any given moment between the price an investor would pay to buy an ETF share and the (lower) price at which an investor could sell a share. This spread is particularly relevant for those engaging in short-term trading — the more an investor buys and sells an ETF, the more his or her proceeds are reduced by the difference between the bid and ask price. Thus evidence of frequent trading patterns in the ETF market further strengthens the suggestion that many investors are dissipating the cost savings they might otherwise gain through investing in ETFs.

Related Reading Is Day Trading Your 401(k) a Good Idea? Deconstructing Index Funds

In sum, ETFs are often both less expensive than typical mutual funds and potentially more tax-efficient. But investors who engage in short-term trading activity frequently squander these benefits. The conclusion is that a buy-and-hold, long-term approach is the best way to capitalize on the inherent advantages of ETFs. Advice of this sort has a familiar ring to it, does it not? 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Field Guide to Exchange-traded Funds (ETFs)

By Randall Rohn
Analyst, mPower

In This Story ETF Pros and Cons The Premium/Discount Dynamic The Case for Greater Tax Efficiency Are They Really Less Expensive?

Amid a flurry of new offerings and burgeoning investor interest, exchange-traded funds, or ETFs, have been much discussed in the financial press lately. In the third quarter alone, ETFs attracted $5.6 billion in inflows, according to a study by New York–based research firm Strategic Insight.

Given the explosion of interest in these funds, now is a good time to take a closer look at them.

minute: read this article at a glance.

Technical Terms Net asset value (NAV) Index fund Arbitrage Brokerage window Bid-ask spread

What exactly is an exchange-traded fund (ETF)? An ETF is essentially a fund that tracks a market index or sector and trades throughout the day on a stock exchange. Traditional index funds have the same goal, but they can't be traded in real time — they trade according to their net asset value (NAV), which is only calculated at the end of the trading day.

Barclays Global Investors has led the way in the recent proliferation of these funds with the addition of over 40 new funds to its menu of ETFs earlier this year, and index-fund giant Vanguard Group has announced plans to introduce ETFs of its own.

Given all of the attention currently surrounding ETFs, you might assume that these products are relatively new to the marketplace. In fact, ETFs have been around for several years. The American Stock Exchange launched Standard & Poor's Depositary Receipts (SPDRs), known as "Spiders" and trading under the ticker SPY, in 1993. SPY is the largest ETF, according to Strategic Insight. The Amex is also behind three other top ETFs: the NASDAQ-100 (ticker: QQQ), Standard & Poor's MidCap SPDRs (ticker: MDY), and Dow Industrials DIAMONDS (ticker: DIA).

ETF Pros and Cons

Fund strategists and financial journalists — not to mention the firms sponsoring the funds — have lauded ETFs as superior alternatives to traditional index funds.

But there have been vocal criticisms of the ETF phenomenon as well. Mercer Bullard, former SEC regulator and founder of investor-advocacy firm Fund Democracy L.L.C., claims that ETFs expose investors to unknown risks due primarily to inadequate representation by ETF sponsors and by the Amex, where the majority of the funds are traded.

Aside from the fact that ETFs can be traded intra-day, their alleged superiority to traditional mutual funds rests primarily on the premise that ETFs are less expensive and more tax-efficient. The chief argument against them revolves around the capacity of these funds to trade at discounts or premiums to their NAV — in other words, the net value of the underlying stocks in the fund's portfolio. The following discussion investigates each of these claims in an effort to determine whether ETFs can be attractive alternatives for a diversified portfolio.

The Premium/Discount Dynamic

One of the most common criticisms surrounding ETFs is the propensity for the funds to trade at a premium or a discount to their underlying NAV. The worry is that, because ETFs trade continuously during market hours, investors may lose money by buying ETFs at a premium and subsequently selling their shares at a discount.

One of the most common criticisms surrounding ETFs is the propensity for the funds to trade at a premium or a discount to their underlying NAV.

The originators of ETFs were acutely aware of the discount/premium issue. In an effort to keep the prices of ETFs in line with NAV, ETFs utilize something known as a creation unit.

Here's how it works. The creation unit consists of a basket of stocks that mirrors the index that the particular fund is designed to track. Institutions and large investment houses assemble the creation units, which typically consist of $5 million to $10 million worth of equity. They then swap the units for shares in the ETF, which they sell to the investing public at the retail level. The institutions, however, reserve the right to convert these retail ETF shares back into creation units at their discretion.

In this way, the intra-day prices of ETFs are generally kept relatively close to the fund's NAV. The convertibility of the creation units and the retail shares acts as a kind of arbitrage.

To illustrate, suppose an ETF is trading at a premium to its NAV. The institutions that put together the creation units could exchange them for ETF shares, which they could then sell at a profit. Similarly, should an ETF be trading at a discount to its underlying NAV, the same institutions could buy the retail ETF shares, exchange them for creation units, and then proceed to sell the component securities at a profit. Such arbitrage activity is an efficient method of mitigating the discount/premium problem. Granted, such a strategy is far less effective when the underlying securities are small and/or thinly traded. The majority of ETFs, however, track major market benchmarks whose component stocks are large, liquid and efficiently traded.

The Case for Greater Tax Efficiency

ETFs are frequently heralded as more tax-friendly than traditional mutual funds. This claim especially resonates with shareholders in the throng of mutual funds that have already made large capital gains distributions this year. Such distributions can result in hefty tax bills, and there are likely to be many more such payouts in the closing months of 2000.

One drawback of conventional mutual funds is that investors are often hit with capital gains taxes even when they don't sell any shares. Portfolio managers of these funds may be forced to sell securities to meet shareholder redemptions — that is, to pay for shares investors are selling back to them — thus triggering taxable gains that must be passed on to the remaining fund shareholders. Long-term investors are the victims.

An obvious benefit of ETFs is that managers are not forced to sell securities in response to shareholder redemptions. Thus, the buy-and-hold investor is not hit with involuntary capital gains bills. While this enhances the tax efficiency of ETFs, it does not mean — as many investors believe — that these funds do not distribute any capital gains to shareholders. They do.

An obvious benefit of ETFs is that managers are not forced to sell securities in response to shareholder redemptions. Thus, the buy-and-hold investor is not hit with involuntary capital gains bills.

Certain ETFs have made regular capital gains distributions in line with their mutual fund contemporaries. A good example is the Standard & Poor's MidCap 400 Depositary Receipts Trust, which has realized a capital gains distribution every year since its 1995 inception.

Nevertheless, the alleged greater tax efficiency is one of the stronger claims of ETFs over customary mutual funds. The reasoning goes beyond the advantage of not having to redeem shares in response to the activity of individual investors, thus triggering taxable capital gains for mutual fund shareholders. It goes back to the financial institutions that convert and exchange retail shares for creation units, and vice versa. Such exchanges are made "in-kind," meaning that the ETF shares are exchanged for the basket of stocks (that is, the creation units) that tracks the underlying index. Why is this important? Because these in-kind transactions are not taxable events. Therefore, the lowest cost shares — the shares that stand to realize the largest capital gains — may be unloaded each time such a transaction takes place. The outcome should be smaller capital gains distributions and a lower tax bill.

Although money held in a 401(k) or other tax-deferred account is not subject to capital gains taxes, the greater tax efficiency of ETFs may make them an appealing alternative to traditional index funds in the taxable portion of a retirement portfolio. Most 401(k) plans offer an option to invest in a regular index fund; ETFs are generally only an option for those plans that allow investment through a brokerage window.

Are They Really Less Expensive?

ETFs are regularly touted as being less-expensive alternatives to investing in traditional index funds. In general, this appears to be the case. For example, Barclays Global Investors recently introduced a bevy of new ETFs. Seven of these funds track indexes also tracked by traditional mutual funds offered by Vanguard Group. Wall Street Journal columnist Jonathan Clements published a column this summer in which he compared the expenses of each of the seven traditional mutual funds with those of the Barclays ETFs. He reports that in two instances the annual expenses were identical. However, the Barclays offerings were cheaper in the other five cases, typically by 4 basis points to 5 basis points.

All other things being equal, given two identical funds, the less-expensive alternative is always superior. But all other things are rarely equal. As Clements points out, the difference in annual expenses he found between the traditional index funds and the ETFs amounts to 4 cents to 5 cents per annum per $100 of the investment. While it's always prudent to seek low-cost investments, savings on this scale is probably not sufficient reason to sell your mutual funds in favor of ETFs.

Determining whether ETFs are truly less expensive than traditional funds necessitates looking beyond their annual expenses.

To measure the total cost associated with ETFs, one should take note that part of their appeal is the fact that they can be bought and sold throughout the trading day. Preliminary statistics suggest that investors are taking full advantage of that ability. To wit, the same Wall Street Journal column cited above reported that through the first five months of the year, the average holding period for Standard & Poor's Depositary Receipts (SPDRs) was just 19 days. The average for the popular NASDAQ-100 Index Tracking Stock over the same period was an astonishing four days. Every time an investor buys or sells ETFs, he or she incurs brokerage fees and other costs associated with trading. The advantages of lower costs and greater tax efficiency that ETFs exhibit over traditional mutual funds are relinquished through active and excessive trading. The accumulated brokerage fees and short-term taxable gains realized from such trading more than counter these advantages.

The average holding period for the popular NASDAQ-100 Index Tracking Stock through the first five months of 2000 was an astonishing four days.

Additionally, conventional mutual funds can generally be bought and sold at NAV, while investors in ETFs must be mindful of the bid-ask spread. This spread is the difference at any given moment between the price an investor would pay to buy an ETF share and the (lower) price at which an investor could sell a share. This spread is particularly relevant for those engaging in short-term trading — the more an investor buys and sells an ETF, the more his or her proceeds are reduced by the difference between the bid and ask price. Thus evidence of frequent trading patterns in the ETF market further strengthens the suggestion that many investors are dissipating the cost savings they might otherwise gain through investing in ETFs.

Related Reading Is Day Trading Your 401(k) a Good Idea? Deconstructing Index Funds

In sum, ETFs are often both less expensive than typical mutual funds and potentially more tax-efficient. But investors who engage in short-term trading activity frequently squander these benefits. The conclusion is that a buy-and-hold, long-term approach is the best way to capitalize on the inherent advantages of ETFs. Advice of this sort has a familiar ring to it, does it not? 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.