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 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, HOLDRS, exchange traded notes (ETNs), and certain exchange traded partnerships (MLPs).

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 2010, ETF's in the U.S. totaled 923 funds holding 992 billion dollars in net assets.

Structure
ETFs investing in stocks and bonds are usually structured as open-end funds or unit investment trusts. Commodities, currencies, and HOLDRS 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..

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, QQQs , and BLDRS ) 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.

Grantor trust
Grantor trusts are registered under the Securities Act of 1933. This structure is used for currency, commodity, and HOLDRS 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. 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.  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."

Exchange traded note
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.
 * 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%).
 * 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 that currency note interest would be taxed as current income regardless of the fact that the payment of interest would not occur until maturity.

Master limited partnership
Some commodity exchange traded vehicles are structured as Master Limited Partnerships (registered under the Securities Act of 1933). Characteristics include:
 * 1) As holders of a MLP, investors are required to report their share of the MLP's income, gains, losses and deductions on tax returns even if there are no cash distributions. Futures contracts are currently taxed at a hybrid rate of 60% long-term and 40% short-term gains, irrespective of the actual holding period.
 * 2) Tax reporting is done with a Schedule K-1.

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. 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.

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.

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.

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.

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

The following banks are major issuers of Exchange Traded Notes:
 * Elements, Bank of America
 * E-TRACS, UBS
 * ipath, Barclays Bank
 * Market Vectors, Morgan Stanley
 * PowerShares ETNs, Deutsche Bank AG, London branch

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

Historical background

 * The History of Exchange-Traded Funds, by ETF Guide
 * Exchange Traded Funds: A White Paper, by Index Funds Advisors. Covers how SEC regulations were modified to create ETFs and introduction of SPDR - the first successful ETF. (Feb 24, 2000)

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"

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