Exchange-traded fund

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, but in the U.S. a number of other investment vehicles including exchange traded notes, HOLDERS, and certain partnerships are often grouped under the exchange traded fund banner.

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 which generally makes the difference between price and NAV very small.

At year end 2009, ETF's in the U.S. totaled 771.1 billion dollar in net assets. For a comprehensive view of the ETF marketplace, refer to ETF Landscape:Industry Review from Blackrock November 2009.

Costs

 * 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.
 *  Expense ratio: the annual management fee for a mutual fund or ETF expressed as a percentage. It is charged directly to the fund/ETF.
 * Vanguard now allows for commission free Vanguard ETF transactions for Vanguard Brokerage accounts. The firm also allows a free conversion of Vanguard index mutual fund shares into ETF shares.

Caveat: 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.

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

The American Stock Exchange web site 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. However, Vanguard ETFs have no tax advantage over the corresponding Vanguard index funds, because the ETF is a share class of the index fund and thus the mutual fund shares the tax benefits of the ETF.

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 instiutional 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 but not subsequently; see the individual providers in the ETF Provider Links section for distribution information.

Many of Vanguard's ETFs were added as share classes to existing mutual funds, and thus avoided the first-year effect; the only Vanguard stock ETF to distribute capital gains other than in its first year is REIT Index, which distributed gains in 2004, 2005, 2006, and 2008. FTSE All-World Ex US Small-Cap, which was created simultaneously as a fund and an ETF, distributed a small gain in its first year (2009) and is currently projected to distribute another small gain in its second year. Consumer Staples Index also distributed a gain in its first year (2004). See Vanguard Funds: Distributions for detailed tax data on individual funds.

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.

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:
 * BGI ishares
 * SSgA
 * Vanguard ETFs
 * Powershares
 * ProShares

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

How to convert mutual funds to ETFs at Vanguard
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.

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.

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


 * 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.

Vanguard ETF Resources

 * Calculate and compare costs for Vanguard ETFs and mutual funds
 * Vanguard Plain Talk: How you can use exchange-traded funds
 * Compare Vanguard ETF's with traditional index mutual funds
 * Vanguard exchange-traded funds—another way to index, a comparison with index funds.

ETF vs. Vanguard ETF share class

 * An Exchange-Traded Fund Or A Conventional Fund —You Can’t Really Have it Both Ways Gary Gastineau, Journal of Indexes, First Quarter, 2001
 * The Anatomy of Tax Efficiency Gary Gastineau, Journal of Indexes, May-June, 2005

General information about ETFs

 * Fund Statistics
 * ETF Statistics (Sept 2009)
 * Exchange-Traded Funds (ETF) Center at Yahoo Finance
 * ETF Liquidity Myth Dispelled, from Yahoo Finance

Tutorials

 * ETF Education Center, a series of articles from IndexUniverse.com
 * ETF Tutorial. A 30-minute pre-recorded webinar that explains what ETFs are and how they work.
 * Course 403: Exchange-Traded Funds, from Morningstar
 * A Guide to Exchange-Traded Funds, from the Investment Company Institute
 * How ETFs work, from Yahoo Finance
 * An Inside Look At ETF Construction, Jim McWhinney, from Investopedia

Forum Discussions

 * Where is the big advantage in ETFs?, A concise list of the pros and cons between ETFs and mutual funds.
 * To ETF or Not to ETF, by Rick Ferri
 * VBS offers free VG ETF trades, qualify for Voyager with 50k, forum discussion

Articles

 * Exchange-Traded Funds Not for Everyone Wilfred Dellva, FPA Journal, 2001 April Issue - Article 12
 * Will McClatchy and Jim Wiandt, "How ETFs Manage a Tax-Efficiency Edge over Traditional Mutual Funds"
 * William J. Bernstein, "The ETF vs. Open-End Index-Fund Shootout"

Academic Papers

 * Ali, Paul Usman and Gold, Martin L.,The New Model Index Fund(undated). MFAS Investment Advisors Research Paper. Available at SSRN: http://ssrn.com/abstract=275593 or DOI: 10.2139/ssrn.10.2139/ssrn.275593
 * Birdthistle, William A., "The Fortunes & Foibles of Exchange-Traded Funds: A Positive Market Response to the Problems of Mutual Funds" . Deleware Journal of Corporate Law (DJCL), Vol. 33, No. 1, 2008 Available at SSRN: http://ssrn.com/abstract=1013614
 * Huang, Jennifer C. and Guedj, Ilan, "Are ETFs Replacing Index Mutual Funds?" (March 31, 2008). Available at SSRN: http://ssrn.com/abstract=1108728
 * Poterba, James M. and Shoven, John B., "Exchange Traded Funds: A New Investment Option for Taxable Investors" (January 2002). MIT Department of Economics Working Paper No. 02-07. Available at SSRN: http://ssrn.com/abstract=302889