Exchange Traded Fund (ETF)

A Fund that trades on an Exchange

What is an Exchange Traded Fund (ETF)?

An Exchange Traded Fund (ETF) is an investment fund that holds assets, such as: stocks, commodities, bonds, gold bars, and foreign currency. An ETF is traded like a stock throughout the trading day at fluctuating prices. They often track indexes, such as the Nasdaq, S&P 500, Dow Jones, and Russell 2000.  Investors in these funds do not directly own the underlying investments, but instead, they have an indirect claim and are entitled to only a portion of the profits and residual value in case of fund liquidation. Their ownership shares or interest can be readily bought and sold in the market.

 

Exchange Traded Fund theme

 

What are the Different Types of ETFs?

There are many types of Exchange Traded Funds, some of the most common include:

Stock ETFs – these hold a particular set of equities or stocks and are similar to an index. They can be treated like regular stocks in that they can be sold and purchased for a profit as well as that they carry management fees and expenses much lower than other traded funds.

Index ETFs – these mimic a specific index like a mutual fund index, but they differ in the way that index ETFs can be bought or sold throughout the trading day. They can cover specific sectors, specific classes of stock, and foreign markets but can only make portfolio changes when changes happen in the underlying index.

Bond ETFs – these are specifically invested in bonds or fixed-income securities and can be bought and sold during the trading day.

Commodity ETFs – hold physical commodities, such as agricultural goods, natural resources, and precious metals.

Currency ETFs – these are invested in a single currency or a basket of various currencies and are widely used by investors who wish to gain exposure in the foreign exchange market without entering futures or forex.  They usually track the most popular international currencies, such as: U.S. dollar, Canadian dollar, Euro, British pound, and Japanese yen.

Inverse ETFs – funds built by using various derivatives to gain profits through short selling when there is a decline in the value of broad market indexes.

Actively Managed ETFs – funds being handled by a manager or a team, who decides the allocation of the underlying asset portfolio.

Leverage ETFs – funds that mostly consist of financial derivatives and debt. These are typically used by traders who are speculative and take advantage of the index’s short-term momentum.

Real Estate ETFs – funds invested in real estate investment trusts (REITs), real estate service firms, and real estate development companies.

 

ETF

 

What are the Advantages Investing in an ETF?

There are many advantages to investing in an Exchange Traded Fund, including:

Costs and benefits of index strategies: ETFs involve a significantly lower expense ratio than that of an average mutual fund. This is in part because of their exchange-traded nature, which places typical costs on the brokers or the exchange, in comparison with a mutual fund, who must bear the cost in aggregate.

Accessibility to markets: ETFs lead the advent of exposure to asset classes that were previously hard to access, and provide investors with the possibility to own emerging markets bonds, gold bullion or crypto-currencies, regardless of the size of the investor. Because ETFs can be sold short, margined, lent and subjected to any other strategies regardless of sophistication, they represent an entirely new opportunity for investors.

Transparency: Hedge funds and even mutual funds operate in a not so transparent manner compared to ETFs. Hedge funds, institutional investors, and mutual funds usually report their holdings on a quarterly basis, leaving investors without an idea whether the fund is following its IPS and adequately addressing risks. Conversely, ETFs generally disclose their daily portfolios, which helps the investor in the portfolio construction process.

Liquidity and Price Discovery: Because they can be bought or sold in secondary markets throughout the day, ETFs are liquid. Often, we hear the phrase ETFs democratize the investment process, and rightfully, as many investors, regardless of their size or sophistication, trade these securities like equities. They trade close to their true Net Asset Value, as their mechanism of creation/redemption constantly balances out the arbitrages in pricing, bringing the value back to its fair price.

Tax Efficiency: Generally, in an after-tax consideration, ETFs pose a major advantage over mutual funds for two main reasons. First, ETFs reduce portfolio turnover and offer the ability to avoid abrupt capital gains (which entail high taxes) by doing in-kind redemptions. Second, ETFs can overcome rules that prohibit selling and realizing (claiming) a loss on a security if a very similar security is bought within a 30-day window, because investors can often sell one fund and replace it with a different fund with different characteristics but similar exposure.

 

Drawbacks of Exchange Traded Funds

Despite the abovementioned benefits, ETFs encounter some challenges as well. For instance, they provide higher exposure to previously unattended asset classes that could bear risks that equity investors might not be familiar with. Ease of access may work against the general public if taken lightly. Some sophisticated examples such as alternative ETFs involve complex or unfamiliar portfolio structures, tax treatments or counterparty risks, which require a deep understanding of the underlying assets.

Additionally, ETFs carry transaction costs that should be carefully considered in the process of portfolio creations, such as Bid/Ask spreads and commissions.

 

Who are the biggest ETF management companies?

As of 2017, there are thousands of Exchange Traded Funds in existence.  If you want to know who the largest fund management companies in the world are, here is a list of the top 10 fund companies ranked by assets under management (from etf.com).

  1. BlackRock
  2. Vanguard
  3. State Street Global Advisors
  4. Invesco PowerShares
  5. Charles Schwab
  6. First Trust
  7. WisdomTree
  8. Guggenheim
  9. VanEck
  10. ProShares

Learn more about BlackRock and Vanguard, as the two dominant leaders in the space.

 

ETF exchange

 

Who are the Authorized Participants in an ETF?

A unique feature of an Exchange Traded Fund is that it has Authozied Participants who help facilitate the market for fund units.

As per regulatory directives, Authorized Participants (APs) are designated to create and redeem ETFs. APs are large financial institutions that have huge buying power and market makers, such as: large broker-dealers, and investment banks and companies. In creating the fund, APs assemble the required portfolio of asset components and turn the basket over to the fund in exchange for a number of newly created ETF shares. When the need for redemption arises, APs return the ETF shares to the fund and receive the portfolio basket.  Individual investors can participate by using a retail broker who trades in the secondary market.

 

ETF Creation/Redemption Process

It was mentioned previously that ETFs involve a process of Creation/Redemption, which is the lifeblood of this type of securities, and is a main differentiator from equities, as ETFs don’t start trading on a stock exchange by means of an Initial Public Offering.

The continuous mechanism by which ETFs operate works as follows:

  1. Large Institutional investors are known as Authorized Participants (APs), who are large market makers, are the only investors who can create or redeem new shares of an ETF. They create new shares of an ETF by transacting with the ETF manager.
  2. On the other hand, the ETF manager communicates what shares it wants to own in the fund (so an ETF tracking SP/TSX will want to own all the securities and in the same weight as the index). This is known as the creation basket.
  3. The APs go to the market and buy the stocks in the creation basket at the right percentages or use the share it holds and delivers this representative basket of securities to the ETF for an equal amount (value) in shares of the ETF. The process can work inversely, this means that an AP that has a block of the ETF can transact it with the ETF manager and receive the equal basket of underlying securities. This second basket is called the redemption basket and is usually the same as the creation basket unless the ETF manager is trying to get rid of a specific set of securities.

This process occurs in large blocks called creation units, often equalling 50,000 shares of the ETF, in a one-to-one rate, one basket of the underlying stocks in exchange for one basket of ETF shares.

As the creation basket is disclosed at the beginning of the day and is available to all market participants, the arbitrage gap varies according to the liquidity of the securities and implied costs, and it makes the price of the ETF to be near around its fair value.

 

Example Exchange Traded Fund Creation/Redemption

To better illustrate this process, consider the following example:

Example: ETF Share creation

Price of ETF trading on the exchange: $32.15

Fair Value of the ETF based on its underlying securities: $32.00

If this is the case, an Authorized Participant (AP) will want to buy the creation basket (the underlying stocks) and will pay $32.00 and exchange it with the ETF manager for a part of the creation unit. The AP now has shares of the ETF that it can sell in the market at the market price of $32.15 and profit $0.10 per share.

In turn, it exerts downward pressure to the price of the ETF and upward pressure to the price of the underlying stocks, until no further arbitrage can be made. For illustrative purposes, this example doesn’t account for AP costs such as trading and fees, as well as hedging costs for cases in which blocks are demanded partially.

 

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