A Primer on Exchange Traded Funds: Purpose, Operation, and Risk

By David E. Stout and Huaiyu (Peter) Chen

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Top 10 ETFs

As reported in the Wall Street Journal (January 11, 2006), ETFs may be the fund industry’s hottest product, with assets now at approximately $289 billion—an increase of 183% since the end of 2002. The Exhibit lists the 10 largest ETFs according to net asset size, as of December 5, 2005. The S&P 500 SPDR (Standard & Poor’s Depositary Receipt) is currently the largest ETF, but the NASDAQ-100 Index Tracking Stock is currently the most highly traded ETF in the U.S. market.

iShares, provided by Barclays, represents the most comprehensive ETF family. Investors can use individual iShares, such as iShares S&P 500 (symbol: IVV) to track the performance of the overall market or any market sector in the U.S. [e.g., iShare Goldman Sachs Network (symbol: IGN) tracks Goldman Sachs Network Index]. International stock indices are also included in the iShares family; investors can invest in the Japanese equity market by purchasing shares of iShare MCSI Japan Index (symbol: EWJ). Because the S&P 500 SPDRs (provided by PDR Services LLC) tracks the same index as the iShares S&P 500, the gross returns on these funds should be similar, but management fees and expenses might produce different net returns. In the same vein as iShares, Vanguard has introduced an ETF family of 20 funds called VIPERs, which also cover various market sectors, industries, and investment styles [for example, Vanguard Financial VIPERs (symbol: VFH)].

Mutual Funds and ETFs: Similarities

At the most basic level, an ETF is an investment (i.e., fund-management) company. The ETF fund-management industry is dominated by three companies: State Street Global Advisors (www.ssga.com), Barclays (www.barclays.com), and Vanguard (www.vanguard.com). Just like other types of investment companies, such as conventional mutual funds, ETFs sell shares (units) to the public and invest the resulting proceeds in a diversified portfolio of securities.

Investment objectives. Mutual funds exist to satisfy the investment objectives of investors. In general, there are stock funds, bond funds, and money-market funds. Within each category are several subcategories of funds. For example, stock mutual funds can be differentiated according to:

• The market capitalization (“market cap”) of the companies in the portfolio (e.g., “large,” “mid,” or “small”)
• The investment objective of the stocks chosen (e.g., “growth,” “value,” or “blended/mixed”)
• The investment sector of the companies selected (sector funds specialize in one particular sector or industry, such as technology, biomedical, energy, or retail)
• The degree of trading performed by the fund manager (passive funds are designed to replicate an index, such as the S&P 500; active funds attempt to outperform an index and other funds by actively trading securities).

Most ETFs are passive funds that track certain indices. As with index mutual funds, ETFs can be organized to invest in any of these market segments, categories, and investment styles. In fact, the list of ETFs is so comprehensive that today investors can use ETFs to cover all the sectors, styles, and market capitalization options associated with ordinary mutual-fund investments.

Mutual Funds and ETFs: Differences

Creation and redemption of shares. While each ETF is registered with the SEC as an “investment company”—either as an open-end fund or a unit investment trust (UIT)—ETFs differ from traditional mutual funds in how shares (units) are created and redeemed.

For a traditional mutual fund (or UIT), only the fund itself can create shares. Investors in such a fund purchase or redeem shares according to the net asset value (NAV) of shares in the fund. In the case of ETFs, however, shares can also be created by a market specialist or an institutional investor (i.e., a large investor, such as a pension fund, mutual fund, insurance company, or bank) by depositing a specified block of securities (i.e., a block of securities that mimics the composition of the index that the ETF tracks) with the ETF. In return for this deposit, the institutional investor (or market specialist) receives a fixed number of ETF shares, some or all of which can then be sold on a stock exchange.

The institutional investor (or market specialist) may, at its discretion, obtain the return of its deposited securities by redeeming with the ETF an equivalent number of the shares it received originally from the ETF. This is an in-kind transaction; that is, institutional investors don’t get cash when they redeem their ETF shares, they get shares of the underlying assets. However, for these transactions there is a minimum trading-volume requirement (50,000-share blocks) imposed by the SEC. For example, assume that a large pension fund wants to create 50,000 shares of iShares S&P 500, to be held as an investment. Barclay, the ETF sponsor, would transfer 50,000 shares of this ETF to the pension fund once it received the corresponding underlying common stocks from the pension fund. In practice, this means that only institutions (such as pension funds) and the very wealthy can afford to deal directly with an ETF.

Trading of ETF shares. Investors in open-end mutual funds can purchase or redeem their shares according to the net asset value (NAV) of a share, defined as the end-of-day market value of the underlying portfolio of the fund divided by the number of fund shares outstanding. Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day at market-determined prices; shares of ETFs are traded principally on the American Stock Exchange (AMEX). Note, however, that trading ETF shares through a broker is the only way for small individual investors to redeem their shares because they are not financially able to perform the aforementioned “in-kind” transactions.

Tax advantages of ETFs. With a regular mutual fund, significant levels of investor selling can force managers to sell stocks in order to meet redemptions, a situation that can result in taxable capital-gains distributions to the remaining shareholders. In contrast, because of the way they are created and redeemed, ETF shares are considered to be created by trading equivalent certificates (the ETF for the many securities that make up the basket); that is, an “in-kind” trade. According to the IRS, this exchange of essentially identical items does not trigger capital gains. Thus, ETF shares allow an investor to delay payment of capital gains tax until the final sale of the ETF shares.

Closed-End Funds and ETFs

A closed-end fund is one with a fixed number of shares outstanding, which shares are traded in an exchange market. Unlike traditional mutual funds, closed-end fund investors cannot redeem their shares directly from the fund companies. Even though both closed-end funds and ETFs are purchased and sold in the open market, the major difference between these two is that ETFs permit large investors to buy or redeem shares in-kind. This unique ETF mechanism offers two big advantages over closed-end funds.

Pricing. Allowing large investors to buy or redeem shares in-kind prevents the trading price of ETF shares from being substantially different from the NAV of these shares. Closed-end fund investors often find their shares trading at a discount or premium. This phenomenon is particularly troubling to investors whose shares are traded at a large discount relative to NAV. For ETFs, however, any inconsistency between trading price and NAV should be slim and short-lived, and perhaps nonexistent once transaction costs are considered. For example, if an ETF share traded at a large discount relative to its NAV, institutional investors could purchase 50,000-share blocks of the ETF shares in the open market at the discounted price, redeem the shares for the underlying assets, and then sell the collection of underlying assets at a profit. In essence, the large-block trading actions of institutional investors would likely drive up prices of the ETF shares and drive down the prices of underlying assets to the point that any discount would disappear.

Similarly, if an ETF share traded at a premium relative to its NAV, institutional investors could accumulate the underlying assets from the market, deposit them with the fund-management company to get ETF shares, and then sell the ETF shares in the market at a profit. The actual transactions aren’t quite this simple, but the idea is the same: A profit opportunity would generate sufficient demand for the mispriced ETF shares to close the gap between their market price and the NAV of the underlying portfolio of securities in the fund. In short, one advantage of ETFs is a built-in mechanism to ensure that they are priced according to the market value of the underlying securities in the fund.

Liquidity. Liquidity is an important consideration for any investment vehicle. Recent research suggests that liquidity could account for as much as 15% of the price of a security (see F.A. Longstaff, “The Flight-to-Liquidity Premium in U.S. Treasury Bond Prices,” Journal of Business, forthcoming). The liquidity of an ETF is not only a function of the trading of the ETF share itself, but is also directly linked to the liquidity of the underling securities; consequently, ETFs are much more liquid than investments in closed-end funds.

ETF investors benefit from this liquidity in two ways. First, such investors might be able to sell their shares for higher prices than closed-end funds holding the same underlying assets. Second, the average bid-ask spread (the difference between the ask price and the bid price of a security) of ETFs is below that of closed-end funds. This spread is, similar to a broker’s commission, a part of the total transaction costs that investors pay. Thus, the lower bid-ask spread associated with ETFs reduces total transaction costs.

In addition, the bid-ask sizes (the trade sizes at which specialists or market dealers are willing to transact) of ETFs are large, which implies that the market for these securities is “deep.” That is, investors in ETFs can execute large orders without adversely moving bid-ask prices.

For example, consider an investor who wants to sell 1,000 shares of an ETF. If the bid size of the specialist is large (here, greater than 1,000 shares), an investor can sell all his shares in one transaction at the current bid price quoted by the specialist. On the other hand, if the bid size is only 500 shares, an investor would have to first sell 500 shares to the specialist. After this transaction, the specialist might feel selling pressure, meaning the investor could sell only his remaining 500 shares at a lower price. In short, larger bid-ask sizes generally benefit the investor.

Economic Objectives of ETFs

Accountants should have a basic understanding of the economic objectives of investments in shares issued by ETFs. Such investments are designed to accomplish the following:

• Provide increased net investment returns attributable to low expense ratios. ETFs resemble index mutual funds but with lower costs. (Management fees for ETFs are generally lower because most ETFs track the performance of an index; therefore, there is no need for research by highly paid managers.) According to Morningstar Inc., management fees on ETFs recently averaged 0.42% of assets (annually), compared with fees of 0.86% for traditional index funds and 1.4% for actively managed mutual funds. A word of caution: Prospective investors should look carefully at the expense history of the specific ETF they are interested in—Morningstar notes that, of the 190 ETFs it tracks, 58 recently had net annual expenses of 0.6% or more. Also, ETF investors pay a brokerage (trading) commission each time they buy or sell ETF shares. As a result, ETFs might not be a good choice for investors making frequent, small investments, unless a special arrangement is made with the investor’s brokerage firm. In the past, these commissions served as a disincentive for retirement investments, as most 401(k) investors have small sums regularly deducted from their paychecks and invested. Nevertheless, some retirement plans are now putting ETFs to use. According to the Wall Street Journal, Invest-n-Retire (www.investnretire.com), a small Oregon company, lumps together ETF trades from investors in its retirement plans, thereby minimizing the commission costs for individual investors.
• Portfolio completion/diversification opportunities. Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries, but do not have the prerequisite expertise in these areas. Given the variety of sector, style, industry, and country categories available, index ETF shares may be able to provide an investor exposure to the desired market segment, or to the market as a whole. For example, an investor might believe that the semiconductor industry will have excellent performance in the near future, but that investing in one or several semiconductor companies would be too risky. One strategy would be to invest in a fund such as the iShares Goldman Sachs Semiconductor Index Fund (symbol: IGW). In the United States, there is a very broad selection of sector-based ETFs, such that investors could use ETFs to mimic the performance of virtually any investment sector in the market. This is attractive not only to individual investors but also to conventional mutual funds. As indicated by the Wall Street Journal (July 6, 2004), mutual fund managers are increasingly using ETFs as part of their investment strategy. Some mutual funds, such as Amerigo (symbol: CLCCX), invest primarily in ETFs.
• Flexible trading. As noted earlier, unlike conventional mutual funds, ETF shares are priced and traded throughout the day. Because the pricing of ETFs is continuous during trading hours, investors will always be able to obtain, and respond appropriately to, up-to-the-minute ETF share prices. Because investing in ETF shares is akin to investing in common stocks, investors have the flexibility to place various types of orders, such as limit, stop, and stop-limit orders. Furthermore, if investors would like to borrow money from their broker in order to invest (i.e., buying on margin), they could purchase ETF shares using the margin provided by their brokerage firm. Finally, as with ordinary stock trades, investors have the added flexibility of short selling their holdings when they anticipate a price-drop on an ETF share. (Short selling entails borrowing securities from a broker and simultaneously selling those securities in the market, with the hope that prices of the borrowed securities will drop so that they can be repurchased and returned to the broker for a gain. Usually, investors who hold short positions can keep these positions as long as they keep adequate equity in their brokerage accounts.)

Risk Exposures

All investments involve certain types of risk, and ETFs are no exception. Some risk considerations associated with investing in ETFs are discussed below.

Tracking error. To the extent that the index tracked by an ETF does not contain cash, a certain amount of tracking error is introduced by the need for the ETF to temporarily hold within the fund, cash dividends received from equity investments held by the fund. That is, ETFs generally hold cash for various time periods throughout each quarter, even though the underlying benchmark index (such as the S&P 500) does not include cash. As such, the fund will not be able to precisely track the targeted index. This is especially true with index ETFs that are organized as UITs, which, by law, cannot reinvest dividends and therefore must hold such dividends temporarily as cash.

Market risk. Market prices for securities and prices of ETF shares fluctuate continuously based on a variety of factors, such as economic conditions, global events, investor sentiment, and security-specific factors. The prospect of a market decline and its impact on security prices—as well as, by extension, on ETF share prices— should be considered general market risk associated with investments in ETFs.

Credit risk. Credit risk refers to an issuer’s ability to make payments of principal and interest when due. An interruption in the timely payment of such amounts, by a company in which the ETF invests, may adversely affect an ETF’s share value or the ability of the ETF to pay dividends. It is important to remember that equity investments (including investments in equity-based ETFs) possess credit risk. To the extent that a company in which the ETF invests is in default or bankruptcy, the equity securities (e.g., common stocks) of that company would lose value. Thus, the credit risk associated with these securities is effectively borne by the ETF.

Interest-rate risk. Prices of bonds tend to fall as interest rates rise, and rise as interest rates fall (and bonds with longer maturities tend to fluctuate more in price in response to such changes). For ETFs that hold bonds in their portfolios, the interest-rate risk can be significant, although most funds hedge this risk through various market instruments.

Growing Importance of ETFs

ETFs are an increasingly important investment vehicle in the U.S. financial markets. Accountants, particularly in their role as business advisors, should have at least a cursory knowledge of innovative securities such as ETF shares. Advisors should become familiar with how investment in ETF shares differs from investment in mutual and closed-end funds, the economic objectives of ETFs, the income-tax considerations of ETFs, and the risk characteristics of investments in ETF shares.