The phenomenal growth of Exchange-Traded Funds (ETFs) is a frequent topic in the financial press. These funds have been warmly embraced by most advocates of low-cost index funds. Vanguard, the leading advocate of index funds, has added exchange-traded share classes to most of its domestic index funds. Most of the press coverage has correctly noted the major advantages of ETFs – low-costs, intra-day trading and high tax efficiency with no material premiums or discounts to the funds’ intra-day net asset value. However, there is a fair degree of misunderstanding about how ETFs work, what sectors of the market are good candidates for ETFs and what sectors are not, why the expense ratios tend to be low, and how most of the funds manage to avoid significant capital gains distributions. This paper attempts to answer these and other questions frequently asked by investors.
For a more up-to-date treatment, see The Exchange-Traded Funds Manual, 2nd Edition,
Chapters 1 and 2.
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Indices are designed for a number of different purposes. The use of stock indices as market indicators predated the idea of a theoretical “market portfolio” by decades.
Understanding the nature of these indices – and understanding the differences among ETFs based on them – requires understanding the answers to six questions:
- Is the index comprehensive or sampled?
- Is the inclusion mechanism rules-based or discretionary?
- How is the index weighted?
- Are inclusion and weighting decisions consistent over time?
- Can the index be sensibly subdivided – e.g., into industrial sectors, or growth and value components?
- Is the index so widely used as a fund template that the cost of its composition changes hurts the return of a portfolio using the index as a template?
See The Exchange-Traded Funds Manual, 2nd Edition, Chapter 5 for additional index discussions.
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Several years ago, I opined that it would be difficult or impossible to convert a conventional actively-managed fund to the ETF format. My feeling was that shareholders who do not value ETF tax efficiency would argue that the loss in portfolio confidentiality was more important to them than any advantage the ETF format offers. My conclusion was premature. The ETF structure does offer an important advantage to all ongoing fund investors.
See The Exchange-Traded Funds Manual, 2nd Edition, Chapters 1, 5 and 7 for more recent thoughts. This will be a major topic over the next few years.
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On the basis of higher sector volatilities, lower fund expenses, lower trading costs, and long-term tax efficiency, the Sector SPDRs are usually the top choice for sector-fund-based risk management and tax-loss harvesting.
See also The Exchange-Traded Funds Manual, 2nd Edition, Chapters 4 and 9 for updated and more comprehensive tax discussions.
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Short selling in ETF shares is a low-risk activity because short squeezes are not possible and most ETF short sales are made to reduce an investor’s overall risk. While short selling will increase ETF trading activity, it is unlikely to have a significant effect on trading volume or trading spreads unless the ETF shares are based on a very popular index like the S&P 500 or the Nasdaq 100. The market for ETF share lending has changed periodically as market makers have changed their inventories of ETF shares to lend in response to changes in the interest rate environment. Perhaps the most interesting aspect of the very large aggregate short interests in many ETFs is the fact that changes in the short interest are often greater than changes in shares outstanding, obscuring the meaning of changes in the total value of nvestor commitments to ETFs.
A more comprehensive version of this paper appeared in Fabozzi, Frank J., Editior, Short Selling, Wiley, 2004 as Chapter 4. For more and more recent discussions of short selling ETFs, see The Exchange-Traded Funds Manual, 2nd Edition, Chapters 9 & 10.
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The growth in exchange-traded funds (ETFs) has been stimulated by the appearance of new services offered by specialized managers. These managers use ETFs as portfolio components. They use passive vehicles -- index ETFs and index mutual funds -- and traditional active management vehicles -- mutual funds and specialized separate account portfolios -- in eclectic combinations. They pursue most of the goals that traditional separate account managers pursue. However, these managers enjoy some unique advantages which often permit them to provide a better investment service at a lower net cost to the investor.
For more recent and comprehensive information on the use of ETFs by investment advisors see The Exchange-Traded Funds Manual, 2nd Edition, Chapters 1, 2, 4, 5, 6, 7, 8, 9, 10 or 11.
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If the mutual fund had not been introduced into the United States in the 1920s, financial markets would be very different today. However, if the development and growth of mutual funds had not attracted about $8,000,000,000,000 ($8 trillion) to today’s “legacy” funds, no investor, no investment manager and certainly no conscientious regulator would suggest that the primary repository of U.S. investors’ financial assets in the 21st Century should have the characteristics of today’s mutual funds. Starting with the position that a few features of today’s mutual funds might be taken as examples of what not to do and taking advantage of available technology, I sketch the outline of a new or “reinvented” fund structure and new investment processes.
My framework for new funds is very similar in some basic respects to the structure of today’s exchange-traded funds. The idea that the ETF has some advantages over the conventional mutual fund is supported by the fact that it took U.S. ETFs less than 12 years to attract over $226 billion in assets. Conventional mutual funds needed more than 66 years to accumulate as much. Certain features of the existing index ETFs need to be modified or, more accurately, generalized to accommodate a wider variety of funds and to overcome some of the weaknesses that are apparent in the existing index ETFs. Some of the features I propose for the new fund structure are closely linked. They clearly work best if adopted as a package. Other features might be as readily implemented separately or as part of a different set of fund procedures.
I begin by describing what I believe are the three most important problems with mutual funds. The features of the new funds that I will emphasize address these problems. While my description of solutions outlines most of the major structural features of the new funds, a number of features will be barely touched upon or omitted to keep the topic manageable. Whatever the final shape of the funds that emerge from a series of changes likely to happen over the next 5-10 years, the result will be a more flexible investment management structure that meets the needs of a wider range of individual and institutional investors better than any fund structure currently available.
Updates of the material from this presentation appear in many chapters of The Exchange-Traded Funds Manual, 2nd Edition, see especially Chapters 1, 5, 6 and 7.
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Capital Gains Overhang
Few investors fully appreciate the significance of the tax efficiency that the exchange-traded fund (ETF) structure provides. The table offers an arresting comparison of the capital gains tax status of the Vanguard 500 mutual fund and the SPDR ETF, two funds tracking the S&P 500 index that have been in existence for a number of years – over 12 years for the SPDR and over 25 years for the Vanguard 500. Both funds have had high rates of asset growth in a generally rising equity market. To make the comparisons as clear as possible, the relationships in the table are stated as percentages, with each fund’s net assets set at 100%.
An update of the SPDR/Vanguard 500 tax efficiency comparison appears in Chapter 4 of the The Exchange-Traded Funds Manual, 2nd Edition, but the transformation of the Vanguard 500 into a partial ETF reduces the applicability of that specific comparison. The difference in tax efficiency between most ETFs and mutual funds remains an important issue, however.
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From a presentation at the Brookings Institution; a revised version was published in Fuchita and Litan, New Financial Instruments and Institutions, (2007) and has been anthologized elsewhere.
One of the best examples of serendipity in the financial markets – from several angles – is the early development of exchange-traded funds. In attributing some features of exchange-traded funds to serendipity, we certainly do not mean to minimize the role of the developers of the early exchange-traded funds. They deserve full credit for the wisdom they displayed in designing the ETFs introduced in Canada and the United States. Our focus is on the interaction of serendipity and financial engineering in the development of some important elements of the exchange-traded fund structure. Some key features became part of the ETF almost by accident, but they are so important that they serve as the basis for revolutionary financial engineering to reshape the U.S. fund industry. Co-authored by Todd J. Broms.
See The Exchange-Traded Funds Manual, 2nd Edition, Chapters 1 and 5 for updated information on the topics addressed in this paper.
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Results from several major studies of index composition changes indicate that trading transparency accounts for more than half of the market impact cost of composition changes in two of the most popular U.S. indexes. The growth of transparent custom index ETFs and the expected introduction of transparent trading in actively managed ETFs will increase investor exposure to trading transparency costs. Fortunately, researchers will be able to quantify the performance penalty from trading transparency.
An updated version of this paper appeared in the Journal of Portfolio Managment, Fall 2008, pp. 72-81, and some of the analysis is extended in The Exchange-Traded Funds Manual, 2nd Edition,
Chapter 5.
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