Exchange-Traded Funds (ETFs): Unveiling the Advantages, Drawbacks, and Beyond
This article is intended for investors who want to learn more about ETFs or improve their understanding of this innovative investment tool. It is not a recommendation or endorsement of any specific ETF or strategy. Investors should always do their own research and consult a professional advisor before making any investment decisions.
Abstract
Exchange-traded funds (ETFs) are a type of investment fund that trade on stock exchanges like stocks. They offer investors a convenient and cost-effective way to access a diversified portfolio of assets, such as stocks, bonds, commodities, currencies, or indexes. ETFs have many advantages over traditional mutual funds, such as lower fees, higher liquidity, tax efficiency, and transparency. However, they also have some drawbacks, such as tracking error, trading costs, and market risk. In this article, we will explain the basics of ETFs, their history and evolution, their regulatory structure, their global footprint, and their role in modern portfolio management.
Estimated Time to Read: Approximately 8 minutes
Category: Instruments
Type: Education Note
Definition of ETFs
Exchange-traded funds (ETFs) are a type of investment fund that trade on stock exchanges like stocks. They are composed of a basket of securities or other assets that track an underlying index or benchmark. For example, an ETF that tracks the S&P 500 index holds all the stocks in the index in proportion to their market capitalization. An ETF that tracks the price of gold holds physical gold or gold futures contracts. An ETF that tracks the performance of emerging markets holds stocks or bonds from countries such as China, India, Brazil, or Russia.
ETFs allow investors to gain exposure to a wide range of markets and sectors with a single transaction. They also offer several benefits over traditional mutual funds, such as:
Lower fees: ETFs typically have lower expense ratios than mutual funds, which means they charge less for managing the fund. ETFs also do not have sales loads or commissions that mutual funds may charge when buying or selling shares.
Higher liquidity: ETFs trade throughout the day on stock exchanges, which means they can be bought and sold at any time during market hours. Mutual funds trade only once a day at the end of the day, based on their net asset value (NAV). This means that investors may not be able to sell their mutual fund shares when they want or at the price they want.
Tax efficiency: ETFs are generally more tax-efficient than mutual funds, because they do not distribute capital gains to shareholders as often as mutual funds do. Capital gains are generated when a fund sells securities within its portfolio for a profit. When a mutual fund distributes capital gains to shareholders, they have to pay taxes on them, even if they do not sell their fund shares. ETFs avoid this by using a mechanism called in-kind creation and redemption, which allows them to exchange securities with authorized participants (APs), who are large institutional investors or market makers. APs create new ETF shares by delivering a basket of securities to the fund in exchange for an equivalent number of ETF shares. Conversely, APs redeem ETF shares by returning them to the fund in exchange for a basket of securities. This way, ETFs do not have to sell securities within their portfolio and trigger capital gains.
Transparency: ETFs disclose their holdings and NAV daily on their websites or through data providers. This means that investors can see what securities or assets the fund holds and how much they are worth at any given time. Mutual funds disclose their holdings only quarterly or monthly, with a lag of several weeks or months.
However, ETFs also have some drawbacks that investors should be aware of, such as:
Tracking error: Tracking error is the difference between the performance of an ETF and its underlying index or benchmark. Tracking error can arise due to various factors, such as fees, rebalancing costs, sampling techniques, dividend reinvestment policies, or market inefficiencies. Tracking error can be positive or negative, meaning that an ETF can outperform or underperform its index. Investors should compare the tracking error of different ETFs that track the same index before choosing one.
Trading costs: Trading costs are the expenses incurred when buying or selling ETF shares on the stock exchange. Trading costs include bid-ask spreads, which are the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept for an ETF share; brokerage commissions, which are the fees charged by brokers for executing trades; and market impact costs, which are the changes in prices caused by large trades that affect supply and demand. Trading costs can vary depending on the liquidity and volatility of the ETF and its underlying market. Investors should consider these costs when calculating their total return from investing in an ETF.
Market risk: Market risk is the risk of losing money due to changes in market prices or conditions. Market risk affects all types of investments, including ETFs. For example, if the stock market declines sharply, an ETF that tracks the stock market will also decline in value. Similarly, if interest rates rise, an ETF that holds bonds will lose value, as bond prices move inversely to interest rates. Investors should diversify their portfolio across different asset classes, sectors, regions, and strategies to reduce their exposure to market risk.
The history and evolution of ETFs
The first ETF was launched in 1993 in the US, and it was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index. SPY is still the largest and most traded ETF in the world, with over $300 billion in assets and an average daily trading volume of over $20 billion. SPY was followed by other ETFs that track various US stock indexes, such as the Nasdaq 100, the Dow Jones Industrial Average, and the Russell 2000.
In 1996, the first international ETF was launched in the US, and it was the iShares MSCI EAFE ETF (EFA), which tracks the MSCI EAFE index of developed markets outside North America. EFA was followed by other ETFs that track various international stock indexes, such as the MSCI Emerging Markets, the FTSE 100, and the Nikkei 225.
In 1998, the first bond ETF was launched in the US, and it was the iShares Core US Aggregate Bond ETF (AGG), which tracks the Bloomberg Barclays US Aggregate Bond Index of investment-grade bonds. AGG was followed by other ETFs that track various bond indexes, such as the Bloomberg Barclays US Treasury Bond, the Bloomberg Barclays US Corporate Bond, and the Bloomberg Barclays US High Yield Bond.
In 2000, the first commodity ETF was launched in the US, and it was the SPDR Gold Trust (GLD), which holds physical gold bullion. GLD was followed by other ETFs that hold physical commodities, such as silver, platinum, palladium, and oil. In 2006, the first commodity futures ETF was launched in the US, and it was the United States Oil Fund (USO), which holds oil futures contracts. USO was followed by other ETFs that hold commodity futures contracts, such as natural gas, corn, soybeans, and wheat.
In 2005, the first currency ETF was launched in the US, and it was the Invesco DB US Dollar Index Bullish Fund (UUP), which tracks the performance of the US dollar against a basket of six major currencies. UUP was followed by other ETFs that track various currency pairs or baskets, such as the euro, the yen, the pound sterling, and the Chinese yuan. In 2006, the first leveraged ETF was launched in the US, and it was the ProShares Ultra S&P 500 (SSO), which seeks to provide twice
How do ETFs work
An exchange-traded fund (ETF) is a type of investment fund that trades on a stock exchange like a regular stock. An ETF typically holds a basket of securities or other assets that track an underlying index, such as the S&P 500, the MSCI World, or the Bloomberg Barclays Aggregate Bond Index. By buying or selling shares of an ETF, investors can gain exposure to the performance of the index without having to own all the individual securities or assets in it.
ETFs are created and managed by specialized firms called sponsors or issuers. These firms design the ETF's investment objective, select the index to track, and determine the fees and expenses of the fund. They also appoint a custodian to hold the fund's assets and an authorized participant (AP) to create and redeem shares of the fund.
ETF Creation Process | Source: Acekias
An AP is usually a large financial institution, such as a bank or a broker-dealer, that has an agreement with the sponsor to facilitate the supply and demand of ETF shares in the market. The AP can create new shares of an ETF by delivering a basket of securities or cash to the sponsor in exchange for a specified number of ETF shares. This process is called creation. Conversely, the AP can redeem existing shares of an ETF by returning a specified number of ETF shares to the sponsor in exchange for a basket of securities or cash. This process is called redemption.
The creation and redemption mechanism helps keep the market price of an ETF close to its net asset value (NAV), which is the value of all the fund's assets minus its liabilities divided by the number of shares outstanding. If the market price of an ETF deviates significantly from its NAV, an arbitrage opportunity arises for the APs. For example, if an ETF is trading at a premium (higher than its NAV), an AP can buy the underlying securities at their market prices, deliver them to the sponsor in exchange for new ETF shares, and sell those shares in the market at a profit. This increases the supply of ETF shares and pushes down their market price toward their NAV. Conversely, if an ETF is trading at a discount (lower than its NAV), an AP can buy ETF shares at their market prices, return them to the sponsor in exchange for the underlying securities, and sell those securities in the market at a profit. This reduces the supply of ETF shares and pushes up their market price toward their NAV.
The creation and redemption mechanism also allows ETFs to be more tax-efficient than traditional mutual funds. Unlike mutual funds, which have to sell securities to meet investor redemptions and generate capital gains taxes for their shareholders, ETFs can transfer securities in kind to their APs without triggering any taxable events. This means that ETF shareholders only incur capital gains taxes when they sell their own shares in the market.
Types of ETFs
ETFs come in various shapes and sizes, offering investors access to a wide range of asset classes, sectors, regions, and strategies. Some of the most common types of ETFs are:
Equity ETFs: These are ETFs that invest in stocks or equity indices. They can cover broad markets (such as U.S., global, or emerging markets), specific regions (such as Europe or Asia), specific countries (such as China or Brazil), specific sectors (such as technology or health care), or specific themes (such as environmental, social, and governance (ESG) or artificial intelligence (AI)).
Fixed income ETFs: These are ETFs that invest in bonds or bond indices. They can cover different segments of the bond market (such as government, corporate, or municipal bonds), different maturities (such as short-term, intermediate-term, or long-term bonds), different credit qualities (such as investment-grade or high-yield bonds), or different currencies (such as U.S. dollar or euro bonds).
Commodity ETFs: These are ETFs that invest in commodities or commodity indices. They can cover individual commodities (such as gold, oil, or wheat), baskets of commodities (such as energy, metals, or agriculture), or commodity futures contracts (such as crude oil futures or corn futures).
Currency ETFs: These are ETFs that invest in currencies or currency indices. They can track the value of a single currency (such as the euro or the yen) or a basket of currencies (such as the U.S. dollar index or the emerging market currency index).
Alternative ETFs: These are ETFs that invest in alternative assets or strategies that are not typically found in traditional portfolios. They can include real estate investment trusts (REITs), infrastructure, private equity, hedge funds, leveraged or inverse funds, volatility funds, or multi-asset funds.
Advantages and disadvantages of using ETFs
ETFs offer several benefits to investors, such as:
Diversification: By holding a basket of securities or assets that track an index, ETFs allow investors to diversify their portfolios across different asset classes, sectors, regions, and strategies with a single trade.
Low cost: ETFs typically have lower expense ratios than mutual funds, meaning they charge less for managing the fund. ETFs also have lower trading costs than individual securities, as they can be bought and sold on an exchange without paying commissions or spreads to brokers or dealers.
High liquidity: ETFs can be traded throughout the day on an exchange, unlike mutual funds, which can only be bought and sold at the end of the day at their NAV. This gives investors more flexibility and control over their entry and exit points and allows them to take advantage of market movements and opportunities.
Transparency: ETFs disclose their holdings and NAV on a daily basis, unlike mutual funds, which may only do so on a quarterly or monthly basis. This gives investors more information and clarity about what they are investing in and how their fund is performing.
Tax efficiency: As mentioned earlier, ETFs can transfer securities in kind to their APs without triggering any taxable events, unlike mutual funds, which have to sell securities to meet investor redemptions and generate capital gains taxes for their shareholders.
However, ETFs also have some drawbacks that investors should be aware of, such as:
Tracking error: This is the difference between the performance of an ETF and its underlying index. Tracking error can arise due to various factors, such as fees and expenses, rebalancing frequency, sampling techniques, cash holdings, dividend reinvestment, market impact, liquidity constraints, or index changes. Tracking error can be positive or negative, meaning that an ETF can outperform or underperform its index.
Premium/discount: This is the difference between the market price of an ETF and its NAV. Premium/discount can arise due to various factors, such as supply and demand imbalances, market volatility, trading inefficiencies, fund distributions, fund closures, or fund conversions. Premium/discount can be positive or negative, meaning that an ETF can trade higher or lower than its NAV.
Counterparty risk: This is the risk that a party involved in a transaction with an ETF fails to fulfill its obligations. Counterparty risk can arise from various sources, such as the sponsor, the custodian, the AP, the exchange, the market maker, the broker-dealer, or the swap provider. Counterparty risk can result in losses for the ETF and its shareholders.
Regulatory risk: This is the risk that changes in laws, rules, regulations, policies, or practices affect the operation or performance of an ETF. Regulatory risk can arise from various authorities,
Regulatory Structure
ETFs are regulated by different authorities depending on their domicile and structure. In the US, most ETFs are registered as open-end investment companies under the Investment Company Act of 1940, and are subject to the same rules and regulations as mutual funds. However, they also need to obtain exemptive relief from the Securities and Exchange Commission (SEC) to operate as ETFs, which allows them to issue and redeem shares in large blocks called creation units through authorized participants (APs), who are typically large institutional investors or market makers. This process enables ETFs to maintain a close alignment between their market price and their net asset value (NAV), which is calculated daily based on the value of their holdings.
Some ETFs in the US are structured as unit investment trusts (UITs), grantor trusts, or commodity pools, which have different regulatory requirements and tax implications.
In Europe, most ETFs are registered as undertakings for collective investment in transferable securities (UCITS), which are harmonized investment funds that can be marketed across the European Union (EU) under a single authorization. UCITS funds are subject to strict rules on diversification, liquidity, leverage, transparency, and investor protection. Some ETFs in Europe are also structured as exchange-traded commodities (ETCs) or exchange-traded notes (ETNs), which are debt instruments that track the performance of an underlying commodity or index.
The global footprint of ETFs
ETFs have gained global popularity, with listings on over 70 exchanges in more than 50 countries. The US is the largest ETF market, followed by Europe and Asia-Pacific (ex-Japan). Prominent providers include BlackRock (iShares), Vanguard, State Street Global Advisors, Invesco, and Charles Schwab in the US; BlackRock (iShares), DWS (Xtrackers), Amundi, Lyxor, and UBS in Europe; and various regional players in Asia-Pacific.
References:
Schneider, David. Index Funds and ETFs: What they are and how to make them work for you. 1st ed. New York: CreateSpace Independent Publishing Platform, 2017.
Hill, Joanne M., Dave Nadig, and Matt Hougan. "A Comprehensive Guide to Exchange-Traded Funds (ETFs)." ISBN 978-1-934667-85-9. 8 May 2015. 2015 The CFA Institute Research Foundation.
