The ABCs of ETFs

By Sheldon Jacobs
The No-Load Fund Investor

       Exchange Traded Funds (ETFs) are increasingly popular investments. Large institutions and individual investors alike use them for exposure to various segments of the financial markets (mainly stocks) and for various trading and investing strategies that require more flexibility than mutual funds provide.
        ETFs are index products offered by such financial-product providers as Barclay's (iShares), State Street (SPDRs ["Spiders"]), Vanguard (VIPERS), Rydex and PowerShares. ETFs resemble regular index mutual funds but trade like stocks. Instead of buying and selling shares of ETFs through mutual-fund companies (and the fund supermarkets of various discount brokerages), investors buy and sell ETFs through regular brokerage accounts, basically like they would any other stock.
        This mode of transaction reflects one of the two main advantages of ETFs as compared to index mutual funds: the ease of buying and selling.
        While regular mutual funds accept investments, exchanges and redemptions any time during the day, the price at which the action takes place is usually the closing price of the current day's trading or the price at the close of trading the next trading day (if the order is received after 4:00 E.T.).
        ETFs, however, can be bought and sold at any time during the trading day at the price prevailing when the order is executed. They can be purchased at the current market price or through a limit order, which limits the price you'll pay for your shares. And they can be sold via stop orders, which limit downside risk. Shares of ETFs can be sold short - borrowing shares to sell them at one price with the intention of buying them back (covering the short) at a lower price. Unlike regular stocks, ETFs can even be sold short on a downtick - a price lower than the most recent trade.
        Because of their enhanced liquidity, ETFs can be helpful tools for portfolio diversification, hedging and tax management. Many ETFs have associated derivatives, and because shares of ETFs can be purchased on margin, they also can juice up a portfolio's return potential (and associated risk).

How They Work

        Unlike regular mutual funds, whose shares are created by the offering mutual-fund company as cash is received from investors or their agents (brokers), shares of ETFs are created by ETF providers in exchange for "in-kind" investments (the actual securities to be in the fund) in large amounts from large financial institutions. In exchange for actual investments that in total mirror the index of the ETF, the large financial institutions receive so-called Creation Units that they then offer on stock exchanges to investors, who can buy them like other stocks. When investors buy and sell ETFs, they aren't causing new shares to be created or old shares to be redeemed; rather, they are simply transacting with other investors - just as when they transact in any stock.
        Actual redemptions from ETFs are also in-kind. They don't occur unless large financial institutions holding large blocks (generally, multiples of 50,000 shares) of an ETF want to exchange their shares for the actual securities underlying the ETF.
        In-kind creation and redemption benefits investors in important ways. First, it helps the market price of ETFs stay close to the combined true value of their underlying investments. Regular closed-end funds (an older type of fund that trades on an exchange), which as a rule do not offer in-kind redemption of their holdings, often trade at discounts of up to 15% from their net asset values. With ETFs, significantly wide discounts would attract large financial institutions and arbitrageurs who would buy large numbers of ETF shares and trade them in for the actual underlying securities (and then sell the securities for a hefty profit). This arbitrage threat helps keep the market prices of ETFs near the combined value of their underlying securities.
        Second, in-kind creation and redemption creates a more equitable process for distributing taxable capital gains among investors. When a regular index mutual fund sells appreciated shares of stock to meet redemption requests, the capital-gains tax liability is spread among each of the fund's shareholders regardless of whether or not the actual selling shareholder has a gain or loss on his position. Unless the mutual fund has offsetting capital losses, all the existing shareholders will receive a taxable capital-gains distribution. But no actual redemptions are necessary when a typical ETF investor sells his position, so no taxable event occurs within the ETF. Therefore, while the specific investor may experience a taxable event, there is no capital gain to distribute among all the ETF's shareholders.
        That does not mean, however, that an ETF will never make a capital-gains distribution. If changes in the underlying index of an ETF cause it to sell securities at a net gain to adjust its portfolio, it will indeed make a capital-gains distribution. However, the in-kind creation and redemption process may help to limit distributions in this circumstance, too. Because the large institutions that create and redeem large blocks of ETF shares are exempt from capital-gains taxes on in-kind transactions, the ETF can meet their redemption requests with low-cost basis shares - exactly the ones that would lead to bigger capital-gains taxes if sold due to changes in the ETF's underlying index. Because only the higher-tax-basis shares are left, taxable capital gains will be lower for the ETF and thus for its investors.

Cost and Comparisons

        After superior liquidity, the second main advantage for ETFs is a low expense ratio - certainly lower than virtually all those of comparative actively managed funds but even generally lower than those of comparable index mutual funds. ETFs have low expense ratios because the products don't cover the costs of distribution or of shareholder accounting, record keeping and servicing. The brokerages through which investors buy and sell shares of ETFs take care of most of those functions and cover their costs.
        Brokerages are compensated for these costs by charging commissions on purchases and sales of ETFs. For many investors, therefore, the cost comparison among various ETFs and similar index funds comes down mainly to the benefit of the ETF's slightly lower expense ratio against the no-load feature of the regular index fund. Investors also should consider bid/ask spreads on ETFs. The large financial institutions that receive ETF Creation Units and offer them to investors profit on the difference between the price at which an investor can buy shares of an ETF and the price at which he can sell.
        The amount, frequency and turnover of your investing impact the cost comparison greatly. ETFs may be the better option for broad index exposure if you want to make one large investment and hold it for many years, for two reasons. One, commissions on ETFs may not increase with share count until you get to a very high number of shares. Two, on a single ETF purchase you may pay the commission only once, while you benefit from the lower expense ratio during your entire holding period. (Keep in mind, however, that limit orders may result in the execution of only a portion of your order and result in additional commissions to sell the remaining shares.) Also, because some index funds may restrict the number of allowable exchanges and charge significant redemption fees if you sell your shares within a set time period, ETFs may be preferable if you plan on trading in and out of the investment more than a couple of times a year.
        Index funds require minimum initial investments. In theory, ETFs require no initial minimum (you can buy only one share if you like). However, given the usual brokerage commission schedules, it seldom pays to buy small amounts of an ETF. If you do, the commission looms large as a percentage of your investment. So, smaller investors who can meet a mutual fund's minimum comfortably will probably be better off doing so than going with a similar ETF. Regular index funds are also a superior choice for investors who invest modest sums at periodic intervals through automatic investment plans.
        ETFs present potential pitfalls in regard to dividends. While you can reinvest dividends in no-load funds automatically without paying a commission, you probably won't be able to do so with-in an ETF. (It depends on your brokerage as well as on the specific ETF in question). Also, because the process by which large financial institutions create and redeem Creation Units of ETFs may result in short holding periods of the actual securities underlying the ETF, a smaller percentage of dividends from ETFs may qualify for the 15% maximum tax on dividends as opposed to your regular tax rate (as high as 35%).
        The type of index being replicated also should impact your choice. The wider the bid/ask spread, the less attractive the ETF should be considered compared to a similar index mutual fund. An ETF that replicates a well known, broadly diversified index of large companies should have a slim bid/ask spread, and should trade at a tiny (or virtually non-existent) fluctuation from the value of its underlying index.

ETF Issuance

        In 1993, State Street Corp, and the American Stock Exchange launched the first ETF: the Standard & Poor's Depositary Receipt, known as the SPDR (pronounced "Spider"). An S&P 500 ETF, the SPDR continues to be one of the largest ETFs by assets and trading volume, but even broader-based stock ETFs are now available. (For example, Vanguard has an ETF version of its Total Stock Market Index Fund). At the other extreme, some new ETFs replicate specific indexes that have been created solely for the ETFs. In many cases, these ETFs reflect indexes of stocks in certain industries or increasingly narrow segments of the stock market; in others, they replicate indexes whose constructions are expected to result in less index change, which in turn should create lower portfolio turnover, lower ETF transaction costs and decrease the likelihood of taxable capital-gains distributions.
        In many cases, ETFs are the only options for investors who want index-fund exposure to certain industries. For example, of the 11 industry-specific ETFs offered by Vanguard, only Vanguard REIT VIPERS has an equivalent regular Vanguard index fund. (The expense ratio of the Investor Shares of Vanguard REIT is 0.21%, vs. 0.12% for the Vanguard REIT VIPERS.) Therefore, as a speculation around a group of core funds, a well-designed industry-specific ETF could make sense for some investors.

ETFs and Best Buys

        ETFs have mainly performed as expected. Most have come close to matching the returns (after expenses) of their underlying indexes and avoiding taxable capital gains.
We include ETFs in our Performance Comparison tables, and because ETF's total costs are comparable to those of recommended index mutual funds, we could include them in our Best Buys portfolios. However, we have not broken tradition and added ETFs to Best Buys. That's mainly because broad-based ETFs would mostly duplicate existing index-fund holdings, while more narrow ETFs would lag the best actively managed mutual funds (which we try to find.) We believe that fund investors can achieve the best risk/reward performance over time by establishing core positions in broadly diversified index funds and investing their remaining liquid assets in superior actively managed funds (and in money-market funds, where appropriate).
       For more information on ETFs, including listings of available ETFs, visit the following web sites: www.amex.com; www.vanguard.com; www.ishares.com; and www.streettracks.com.
       Editor's Note: Sheldon Jacobs is editor of The No-Load Fund Investor, P.O. Box 3029, Brentwood, TN 37024, 1 year, 12 issues, $139, www.noloadinvestor.com. The No-Load Fund Investor newsletter covers 996 no-load and low-load funds, reports on the top twenty no-loads, fund news and Best Buys in each newsletter.