Barchart.com ETF Research

ETF Research written by the Barchart.com ETF Research Team

Last Updated: August 4, 2010

Table of Contents

1. Introduction
2. Index-based passive ETFs versus actively managed ETFs
3. What exactly is an ETF anyway?
4. What is an Exchange-Traded Note?
   
   

Introduction

An exchange-traded fund (ETF) is simply an investment pool that holds a specific set of underlying assets. Shares in an ETF trade just like shares of a regular stock on a stock exchange. An investor can buy or sell shares of an ETF just like shares of a regular stock through his or her brokerage account. Each ETF has a unique ticker symbol just like a stock. ETFs trade on all the major U.S. exchanges including the New York Stock Exchange, Nasdaq, and the American Stock Exchange.

The largest ETF is the "SPDR S&P 500 ETF" (ticker SPY), or "Spider" for short. The SPDR S&P 500 ETF had over $80 billion in assets under management as of early August 2010, making it by far the largest ETF. The SPDR S&P 500 ETF tracks the S&P 500 index and was the first ETF, launched in 1993. This ETF has a very low expense ratio of 0.09% (9 basis points), giving investors an attractive way to gain exposure to the S&P 500. The sponsor for the fund is State Street Global Advisors.

Figure 1 shows a list of the 20 largest ETFs. This list illustrates the wide variety of investment sectors covered by ETFs, including stock industry sectors, overseas stocks, gold, currencies, fixed-income securities, and many others. This is just a small sample of the wide variety of ETFs that are available. These top 20 ETFs together have over $300 billion in assets under management.

ETFs have become very popular over the past two decades. Figure 2 illustrates that there were 797 ETFs in existence at the end of 2009, more than doubling in number over just the past 3 years, according to the Investment Company Institute. ETFs held a total of $777 billion in assets at the end of 2009, representing a compounded annual growth rate of 28% over the 5-year period of 2004-09.

While the ETF industry has grown sharply in the past decade, Figure 3 illustrates that the ETF industry is still dwarfed by the mutual fund industry. At the end of 2009, the mutual fund industry still held 91% of investment company assets, as opposed to just 6% held by the ETF industry. However, recent trends in the industry are likely to continue and the ETF industry is likely to continue to build market share while the mutual fund industry is likely to lose market share.

One of the main reasons for the popularity of ETFs is lower fees. The average fee for the top 20 ETFs is only 0.27% with no front-end or back-end expense loads and no broker sales commissions. The investor only has to pay the usual trading commission to his or her brokerage firm to buy or sell the stock, and the ETF fund has to pay its sponsor an average of 0.27% to run the fund (smaller ETFs generally charge higher expenses in the range of 0.60% to 0.75%), thus slightly reducing the return to the investor on the fund.

ETF expense fees are low partly because the ETF sponsor is simply tracking an index and does not need to have a high-priced stable of investment managers trying to pick stocks. In addition, ETF sponsors do not pay sales commissions to brokers or financial advisors, thus keeping their costs low. This stands in contrast to the mutual fund industry which generally charges high fees to cover active investment management and 12b-1 sales and advertising fees.

ETFs have become increasingly popular for a variety of reasons other than low expenses, including the following:

• Wide range of investment options - ETFs cover virtually all investment sectors including stocks, fixed income, commodities, real estate, and alternative investments.
  
  
• Transparency – The ETF sponsor discloses the fund’s holdings and weights on a daily basis, allowing an investor to better assess the risk of the portfolio, as opposed to many mutual funds that do not provide detailed disclosures of their holdings, which makes it more difficult to assess the underlying risks of the portfolio.
  
  
• Liquidity – Bid/offer spreads for ETFs are typically tight and the ETF price is typically close to its net asset value (NAV) because of the active participation in the ETF market by market makers and arbitragers who encourage an efficient market.
  
  
• Ease of Trading – An ETF can be purchased and sold directly from any brokerage account just like a stock at any time during the trading session.  An investor who buys or sells an ETF immediately knows his or her exact transaction price, unlike a mutual fund, which simply assigns a NAV price at the end of the day.  An investor can use the full range of orders for ETFs, including limit orders or stops, and can also short an ETF.  There are also options available for many ETFs, meaning investors can engage in option strategies on ETFs.
  
  
• Diversification – ETFs provide any easy way for an investor to own a diversified portfolio in a particular investment sector, which is better than picking just a few individual securities to represent a sector.  Diversification typically brings lower risks and higher risk-adjusted returns.  Most ETFs are required to meet certain diversification targets under the tax law and the Investment Company Act.
  
  
• Tax advantages – There can be tax advantages from investing in ETFs since investors in ETFs typically face little or no capital gains tax distributions, unlike a mutual fund where an investor can get a substantial capital gains tax distribution near the end of the year due to the high level of stock trading in a mutual fund as compared with an ETF.  ETF funds do most of their business with non-taxable exchanges of in-kind security baskets and typically only need to buy or sell stocks when the index weighting is periodically changed.  An investor will still have to pay a capital gains tax on an ETF if he or she ultimately sells the ETF at a profit, but that investor at least does not usually have to pay any significant amount of tax on capital gains distributions while he or she holds the ETF.
  
  
• Leverage – Some ETFs offer leverage, meaning an investor can get two or three times the price movement of a non-leveraged fund.  This allows more aggressive investors to take a bigger position while posting less cash up front.
  
  
• Short  or Inverse ETFs – Some ETFs take short positions, meaning an investor can buy the ETF and get short exposure to the market without going through the complications of setting up a short position in his or her brokerage account.

Index-based passive ETFs versus actively managed ETFs

Most ETFs track a passively-managed index that is designed to track the performance of a particular investment sector.  A passively-managed index follows pre-set, objective rules and does not involve making a subjective judgment as to which particular component securities will rise or fall. 

However, a new breed of ETFs has emerged that are actively managed.  In an actively managed ETF, an index manager will shift the asset holdings with a subjective view towards beating a benchmark.  As of the end of 2009, only 22 of the 777 ETFs that were in existence were actively managed ETFs with about $1 billion in combined assets.  Actively-managed ETFs have had a slow start but are likely to expand in the future.

What exactly is an ETF anyway?

An ETF is simply an investment pool that holds a specific group of underlying securities as defined by its prospectus.  Each share in an ETF represents partial ownership of that investment pool.  An ETF sponsor such as iShares, State Street, or PowerShares, creates and then operates the ETF on a daily basis.  The fund pays the ETF sponsor a fee to operate the fund.  All ETFs are registered with U.S. regulatory agencies, usually the Securities Exchange Commission.

ETFs are open-ended, meaning that the number of shares in the fund can rise or fall depending on demand.  This open-ended structure is a key feature that has made ETFs so popular and flexible.  The open-ended nature of the fund helps to keep the ETF price close to its underlying net asset value (NAV), or the theoretical price of its underlying assets.

The open-ended nature of an ETF is different from a closed-end fund which has a fixed number of shares and can sometimes trade at a substantial discount to its net asset value for long periods of time during a bear market when there is little demand for the fund.  If an investor wants to sell a closed-end fund during a bear market, he or she may have to sell the fund at a price substantially below its fair market value, thus leaving some chips on the table.  An ETF, on the other hand, usually trades close to its fair market value, meaning that the investor can buy or sell the ETF without leaving chips on the table.

An ETF trades close to its NAV in part because an ETF is fairly easy to arbitrage against its underlying securities.  If an ETF price should happen to rise significantly above the NAV of its underlying securities, then an arbitrager can simply short the ETF shares and buy the underlying basket of securities, thus capturing the spread as a profit and working out of the trade when values come back into alignment.  On the other side of the coin, if an ETF price is trading below its NAV, then an arbitrager can buy the ETF and take a short position in the underlying securities, thus capturing the spread.  Either way, the actions of the arbitrager cause the price between the ETF and its underlying securities to converge and stay in sync.   The actions of market makers and arbitragers also provide liquidity to the market and keep the bid-offer spreads tight for investors.

An ETF also trades close to its NAV because of the process by which market makers can buy or sell blocks of ETF shares with the ETF sponsor.  Specifically, "Authorized Participants" (AP) are market makers or specialists that register with the ETF sponsor and are thereby allowed to engage in large block transactions directly with the ETF sponsor.  If an AP sees strong demand for the ETF shares, then the AP can buy a large block of shares from the ETF sponsor and pay for that block with either cash or an in-kind delivery of the underlying basket of securities.  The block of shares, which is usually anywhere from 25,000 to 100,000 shares, is called a "creation unit."  The AP can then sell these new ETF shares into the marketplace, or can use them as part of an arbitrage that was already set up ahead of time.  By the same token, if demand is low for an ETF and investors are heavily selling the ETF’s shares, then an AP can buy a large quantity of ETF shares in the open market and then sell them as a block back to the ETF company, receiving in return either cash or the basket of underlying securities.  The ETF sponsor then effectively retires these shares and the outstanding number of shares declines.

The "assets under management" figure for an ETF is simply defined as the number of shares outstanding multiplied by the ETF price.  The ETF "assets under management" figure is similar to a market capitalization figure for a stock, except that the number of shares outstanding for an ETF typically changes much more often than for a corporation.  It is worth noting that an ETF’s "assets under management" figure can move for two reasons, either because of a change in the ETF price or because of a change in the number of shares outstanding.

What is an Exchange-Traded Note?

An exchange-traded note (ETN) is a fundamentally different product than an exchange-traded fund (ETF).  An ETN is a note issued by a large financial institution that provides an investor with a return linked to the performance of a specific underlying asset.  The main advantage of an ETN is that the product can be linked to assets that might be difficult for an ETF to hold directly. 

The largest ETN is Barclay’s iPath Dow Jones Commodity Index (ticker: DJP).  This ETN pays a return based on the performance of a theoretical commodity portfolio with a weight of 30% energy, 21% grains, 19% industrial metals, 12% precious metals, 2% livestock, and 16% other commodities.

An ETN does not actually hold any assets but simply represents an obligation by the financial institution to pay a return based on the performance of the underlying asset.  An ETN has substantially more risk than an ETF because the value of the ETN depends in part on the credit rating and reliability of the financial institution backing the ETN.  If that financial institution should go bankrupt, then the ETN will have little or no value and the shareholder could lose his or her entire investment.  In fact, this happened when Lehman Brothers declared bankruptcy in September 2008, causing the shut-down of three Lehman ETNs, the Opta Lehman Commodity, Opta Lehman Agriculture, and Opta Lehman Private Equity ETNs.

With an ETF, by contrast, if the ETF sponsor should go bankrupt for some reason, the stand-alone ETF investment fund will be liquidated and the cash proceeds will be distributed to shareholders.  That would inconvenience the shareholder, but should not result in any significant financial loss for the investor.

From the Barchart.com ETF Research Team
Last Updated:  August 4, 2010
________________________

Copyright© 2010  Barchart.com, Inc.  All rights reserved. 330 South Wells Street, Suite 612, Chicago, Illinois 60606-7110 USA • E-mail: info@barchart.com • Website: www.barchart.com.