Everything you wanted to know about Exchange-Traded Funds but were afraid to ask
Around the middle of 2015, assets under management (AUM) in exchange-traded funds (ETFs) surpassed the level of AUM in hedge funds. Since then the hedge fund industry has regained its top position as AUM in both industries has dropped below $2.9 trillion but, still, this is quite an achievement for an industry that’s twenty-something. According to industry research analysts, ETFGI, at the end of October 2015, there were 4,344 ETFs holding $2.867 trillion across the globe. Ten years ago, there were 450 exchange-traded funds globally with AUM of $416 billion. AUM has grown at a compounded annual growth rate of over 21 percent. There’s been a lot happening there. On the hedge fund front, Hedge Fund Research (HFR) reports that, at the end of the third quarter 2015, global hedge fund assets experienced the largest decline since the financial crisis. AUM fell by $95 billion to a total of $2.87 trillion.
An exchange-traded fund is an investment company that can be either an open-end company or a unit investment trust (UIT). Generally, an investment company pools the resources of investors and invests the larger aggregated sum. This saves transaction costs that can be passed on to investors and allows for greater diversification than the individual investor might be able to achieve on his own. Mutual funds are, perhaps, the best known type of investment company. Under the Investment Company Act of 1940, mutual funds are referred to as open-end investment companies. The open-end prefix simply means that the number of shares the company might issue is not fixed. The company can, on a continuous basis, issue shares to and redeem shares from investors who deal directly with the company. For this reason, open-end companies are, with a few limited exceptions, prohibited from issuing senior securities, i.e. securities that can be repaid from the company’s assets before the issued shares.
But open-end exchange-traded funds differ from their mutual fund cousins in two important ways. Firstly, whereas regular mutual funds deal directly with retail investors, ETFs do not. Rather, an ETF will contract with large broker-dealers and financial institutions, known in the trade as ‘Authorized Participants’ in large lots of shares, typically at least 50,000, that are called ‘creation units’. Authorized Participants then resell the ETF shares on the secondary market to individual investors, institutions, or firms that undertake to be market makers in the ETF. Generally, the Authorized Participants do not buy creation units with cash. Instead they will purchase them with securities that track the ETF’s portfolio of securities.
Secondly, regular mutual funds can only be purchased or redeemed at the end of the trading day. If you purchase shares in a mutual fund, the trade will be executed at the next Net Asset Value (NAV) of the fund which is calculated after the market closes. NAV is the value of all assets less all liabilities. ETFs, however, trade throughout the day, like stocks, based on their Intraday Indicative Value (IIV). IIV is calculated every 15 seconds or so and is a best computation of the ETF’s NAV.
There are other differences between regular mutual funds and exchange-traded funds. Investment in a regular mutual fund typically runs between $1,000 and $10,000 whereas it’s possible to purchase a single share in an ETF. No short sales are permitted with regular mutual funds but such transactions are allowed with ETFs.
An exchange-traded fund may also be a Unit Investment Trust (UIT). The main difference between an ETF that is open-ended and one that is a UIT is that the UIT does not actively trade its investment portfolio. Nor does it have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust. A portfolio of securities is bought when the trust is created and that portfolio is held until the trust is dissolved. Since the investment portfolio of a UIT is fixed, investors more or less know what they are investing in for the duration of their investment.
The first exchange-traded funds were funds that tracked the performance of major indexes. Funds of that type continue to be the most popular. But a large variety of new funds attempt to track bond indexes and indexes of foreign securities.
There are a number of advantages to investing in exchange-traded funds. They generally have lower transaction costs and operating expense ratios than corresponding mutual funds. ETFs also tend to be more transparent. A large number publish information on their holdings every day. The mutual fund industry tends to abide by the requirements for quarterly disclosure. In certain circumstances, since ETF shares are redeemable by securities rather than cash, they may be more tax efficient. If they were redeemed for cash, the fund might be subject to capital gains tax which would then be passed on to investors.
Exchange-traded funds may be the new kids on the block but they’re now a mainstay of the investment establishment. They combine the advantages of mutual funds and stock trading. They cover entire industries or just segments. No matter his risk profile, an investor is bound to find one that suits his preferences.