Exchange-traded fund

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An exchange-traded fund, or ETF, is a registered investment company. Other forms of the registered investment company include mutual funds, closed-end funds, and unit investment trusts. Legally, an ETF is classified as an open end company or unit investment trust, [1] but in the U.S. a number of other exchange traded products which are not regulated investment companies are often grouped under the exchange traded fund banner. These products include exchange traded grantor trusts, exchange traded notes (ETNs), and certain exchange traded partnerships (MLPs). [2]

ETFs are like mutual funds in that they hold a collection of assets, usually stocks, bonds or other securities. Like closed-ended funds, ETFs trade on the market at a premium or discount from their net asset value (NAV). However, unlike closed-end funds, which often trade at large discounts or premiums to NAV, a special procedure for creating or redeeming shares allows institutional investors to perform arbitrage by swapping blocks of securities for ETF shares. This creation/redemption procedure generally makes the difference between price and NAV very small.

At year end 2012, ETF's in the U.S. totaled 1,194 funds holding 1.337 trillion dollars in net assets. [3] Globally, there were 2,747 ETFs in mid-2011. [4]

Structure

SEC: Distinguishing Features of ETFs
  • ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as "Creation Units."
  • Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase Creation Units are frequently institutions.
  • After purchasing a Creation Unit, an investor often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of Creation Units).
  • Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.
-- SEC: Exchange Traded Funds


ETFs investing in stocks and bonds are usually structured as open-end funds or unit investment trusts. Commodities and currencies are usually structured as either grantor trusts, Exchange Traded Notes (ETNs) or as Master Limited Partnerships (MLPs). The following chart allows one to more easily visualize the four major ETF product structures.

Open end fund

The most flexible and most common form of ETF structure is the open end fund, which is registered under the Investment Company Act of 1940. This structure has the following characteristics:

  1. The fund has a board of directors.
  2. The fund can replicate or sample an index.
  3. The fund can invest in derivatives.
  4. The fund can engage in security lending. Some ETF providers (including Vanguard) allocate all security lending income to the ETF; other ETF providers (among them Ishares) divide security lending income between the ETF and the management company.
  5. Dividends are immediately reinvested and paid to shareholders (monthly or quarterly).
  6. Tax reporting is done with an IRS 1099 document. [5].

Unit investment trust

Unit investment trusts (UITs) are registered under the Investment Company Act of 1940. While most ETF providers use the open end structure, a number of large ETFs (SPDRs[6], QQQs[7], and BLDRS[8]) utilize the UIT structure. Characteristics include:

  1. As a trust, the fund has no board of directors. The trust must be periodically renewed.
  2. The fund can only replicate an index.
  3. The fund cannot invest in derivatives.
  4. The fund cannot lend its securities.
  5. Dividends are not reinvested in the fund, but are held until paid to shareholders quarterly or annually. The ETF can be subject to cash drag.
  6. Tax reporting is done with an IRS 1099 document. [9]

Grantor trust

Grantor trusts [10] are registered under the Securities Act of 1933. This structure is used for currency [11],and commodity exchange traded vehicles. Characteristics include:

  1. The trust invests in a customized basket of securities that remains fixed (for HOLDRS stocks can be removed via merger and acquisition).
  2. The investor is considered as directly owning the underlying assets in the trust. Thus, the shareholder receives all company annual and semiannual reports, and all company proxies.
  3. Dividends are distributed directly to shareholders and are not reinvested.
  4. Tax reporting is done through a Grantor Trust Letter.
  5. Tax reporting can be complicated. Gold bullion and silver bullion ETFs are taxed as collectibles, subject to long term capital gains tax rates up to 28%, and the small sales of bullion used to pay trust expenses are considered taxable sales for shareholders that must be reported each year. [12] In some instances, commodity ETFs using futures contracts must mark to market the futures positions at year end and investors are taxed each year on any gains, even if you don't sell the ETF. Capital gains on future contracts, regardless of holding period, are currently taxed at a hybrid rate of 60% long-term and 40% short-term gains. [13] Etfguide.com states: "For investors in the highest tax bracket, this 60/40 split creates a maximum blended capital gains tax rate of 23%. The tax burden is reduced for investors in lower income brackets." [14]

Exchange traded note

Imbox notice.png On July 12, 2012 FINRA released an investor alert [15] cautioning investors about the risks involved when investing in ETNs. [16]

Exchange traded notes are registered under the Securities Act of 1933. ETNs track a wide assortment of asset classes: stocks, bonds, currencies, commodities. Characteristics include:

  1. ETNs are senior, unsecured, unsubordinated debt securities issued by banks. They are subject to both investment risk and credit risk. In 2008, the failure of Lehman Brothers resulted in the delisting of the firm's three ETNs. [17]
  2. ETNs track a benchmark index. At maturity an investor receives a cash payment equaling the performance of the benchmark, less fees. The most representative fee is 0.75% per annum (range 0.30% - 0.89%).[18]
  3. ETNs, as debt instruments, do not have a net asset value; however, current intrinsic value is expressed by an Intraday Indicative Value (IIV) computation.
  4. Most ETNs are considered by sponsors to be prepaid contracts, with tax liability deferred until maturity, liquidation, or sale by the investor. This tax status is subject to change at the discretion of the IRS; in 2007 the IRS ruled [19] that currency note interest would be taxed as current income regardless of the fact that the payment of interest would not occur until maturity. [20]

Investing with ETFs

General information about ETFs

Tutorials

Forum discussions


Costs

ETFs are subject to the costs of managing the portfolio as well as transaction costs when buying and selling the stock. Here is a breakdown of the costs you will incur:

  • Expense ratio: the annual management fee for a mutual fund or ETF expressed as a percentage. It is charged directly to the fund/ETF.
  • Commission: the up-front charge by your broker to buy or sell a stock or ETF.
  • Bid/ask spread: the price difference between what a seller asks and what a buyer offers for a stock or ETF.
  • Premium and discount: the difference between the trading price and the NAV of an ETF.

When buying or selling ETFs, consider using a limit order to obtain the best price.

The New York Stock Exchange lists the daily closing bid-ask and premium-discount information for many popular ETFs.

Taxes

The ETF structure is likely to make stock ETFs more tax-efficient than stock mutual funds.

When a mutual fund or ETF sells a stock, it has a taxable capital gain (or loss) equal to the difference between what it received and what it paid. When an institutional investor converts shares of an ETF to stock, the ETF provider can give away the shares of stock with the lowest purchase price; these are the shares which would have the highest gain if sold. Thus ETFs can often reduce the capital gains they must distribute. The ETF redemption process does not reduce dividends; therefore, taxable bond and REIT ETFs, asset classes with total returns comprised primarily of non-qualified dividend income, still have a high tax cost.

The redemption process is more effective in reducing capital gains when the ETF has purchased shares at a wide range of prices. Therefore, many ETFs distributed capital gains in their first year or two of operations, but not subsequently; see the individual providers in the ETF Provider Links section for distribution information on individual ETFs.

A potential tax disadvantage to the creation-redemption process is that ETFs may redeem stocks which have paid a dividend before meeting the 61-day holding requirement for qualified dividends; as a result, some ETFs have fewer qualified dividends than similar mutual funds. [21]

Most Vanguard ETFs have no tax advantage over the corresponding Vanguard index funds, because in most cases the ETF is a share class of the index fund and thus the mutual fund shares the tax benefits of the ETF.

Many of Vanguard's ETFs were added as share classes to existing mutual funds and were able to avoid the first-year effect of distributing capital gains. FTSE All-World Ex US Small-Cap, which was created simultaneously as a fund and an ETF, distributed small gains in its first two years (2009 and 2010), and Consumer Staples Index also distributed a gain in its first year (2004). In addition, REIT Index, which added an ETF class to an existing fund which generates a lot of gains, distributed gains in 2004, 2005, 2006, and 2008. See Vanguard funds: distributions for detailed tax data on individual funds.

Risks

With the global increase in the number of ETFs and the complexity of some of them (as is the case with Synthetic ETFs), three international bodies have expressed worries about them. See Too Much of a Good Thing, The risks created by Complicating a Simple Idea in The Economist, June 23, 2011.

How to convert mutual funds to ETFs at Vanguard

Vanguard ETF Resources

Wiki Vanguard ETF Resources


It is possible to convert conventional mutual fund shares to ETFs without any tax consequences. At Vanguard, this is now free, and is possible at other brokers which may charge a fee. To do this at Vanguard, you need to first open a Vanguard Brokerage Account to hold the ETF shares, then call Vanguard Brokerage at 866-499-8473 to do the conversion over the phone.

Imbox notice.png

When converting from a mutual fund to an ETF, do not sell the fund if it has a gain or a taxable event will occur. Contact Vanguard and request a conversion, which will be done at NAV as an exchange from one type of share class to another.[22]

Redemption fees don't get charged when you convert shares to ETF (or Admiral shares).

The conversion rate is determined by the closing NAV of the ETF (not market price) and the closing NAV of the mutual fund using the below formula. If the formula doesn't produce a whole number you get fractional ETF shares for the remainder.

  • Number of ETF shares = number of mutual fund shares X mutual fund NAV / ETF closing NAV

Notice ETF Market Price is not in the equation.

If you convert on a premium day, you'll get a bump. If you convert on a discount day, you'll get dinged. But either way, it's based on the underlying NAV's, so you'll go back once the premium or discount changes. You are not actually selling and buying, so it shouldn't make a difference in the long run. [23]

Here's the timeline from a user's experience of converting Vanguard funds held in a Vanguard IRA mutual fund account.[24]

  • Tuesday afternoon applied for VG brokerage acct's online
  • Wednesday afternoon/evening sign some exchange agreements online to open the brokerage account.
  • Thursday morning called Vanguard at 866-499-8473 to do the conversion of REIT and FTSE ex-US small index funds.
  • Friday AM the mutual fund shares disappeared (be prepared as you see a huge drop in your account balance)
  • Saturday AM the ETF shares appeared, using above formula numbers were correct using Thursday's closing NAV's.

See also

References

  1. SEC: Exchange Traded Funds
  2. ETF Guide: ETF History
  3. ICI: 2013 Factbook
    Number of ETFs and Total Net Assets (Billions of Dollars)

    (view Google Spreadsheet in browser or download as xls, ods, or pdf)

  4. Too Much of a Good Thing, The Economist, June 23, 2011
  5. History of ETFs
  6. SPDR: Standard and Poor’s Depositary Receipts. An ETF that holds shares of all the companies in the Standard & Poor’s 500 Composite Stock Price Index (S&P 500). Spiders (SPDRs)
  7. QQQQ: Based on the NASDAQ-100 Index. Powershares QQQ
  8. BLDRS: Baskets of Listed Depositary Receipts. Based on The Bank of New York Mellon ADR (American Depositary Receipt) Index. BLDRS Funds
  9. History of ETFs
  10. History of ETFs
  11. Rydex Currency Shares
  12. See Ishares Grantor Trust Tax Information
  13. ETF Product Structures
  14. The Case for Commodities
  15. Exchange-Traded Notes-Avoid Unpleasant Surprises, FINRA news release, Retrieved 12 July 2012.
  16. Exchange-Traded Notes-Avoid Unpleasant Surprises, FINRA, Retrieved 12 July 2012.
  17. ETN Credit Risk May Outweigh Benefits For Some, Investopedia
  18. Fee structures for ETNs are available:
    • Elements
    • ETRACS
    • ipath
    • Market Vectors ETNs are priced at 0.55% and 0.65% per annum.
    • Powershare ETNs are priced at 0.75% per annum.
  19. IRS Rev. Rul. 2008-1
  20. History of ETFs
  21. Gus Sauter comments on Vanguard ETF structure, forum discussion with quotes from Vanguard
  22. Free ETFs at VG. But why ETFs?, forum discussion
  23. Conversion of mutual funds to corresponding ETF question, forum discussion
  24. WellsTrade can convert Vanguard funds to ETFs for free, forum discussion

External links

For a comprehensive view of the ETF marketplace, refer to the following annual reviews of the ETF marketplace:

ETF providers

The five largest ETF providers hold $544 billion of the $573 billion in total ETF assets under management. (06/30/08)[source:Indexuniverse.com]. Here are links to the five major ETF providers ETF websites:

The following banks are major issuers of Exchange Traded Notes:

A complete list of ETF providers can be found at ETF Directory.

Historical background

Articles

ETF vs. Vanguard ETF share class

Bibliography