Frequently Asked Qeustions About ETFs
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1. What are Exchange-Traded Funds (ETFs)?
An ETF is a fund with shares that investors can buy or sell throughout the daily trading session on a stock exchange. Currently ETFs that are available in the United States are all index funds, but actively-managed ETFs will be available in the future. Like conventional mutual funds, each ETF holds a portfolio of equity or fixed-income securities. Individually, and in combinations, ETFs offer investors diversification and participation in a variety of investment objectives and strategies.
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2. How are ETFs different from conventional mutual funds?
In contrast to conventional mutual fund shares which investors usually buy from the fund and redeem by selling shares back to the fund, most investors buy and sell ETFs like they buy and sell stocks: on the stock market. An investor can buy and sell ETFs at market-determined prices any time during the trading day. Any kind of order that can be used to buy or sell a stock can be used in trading ETFs, although simple market orders and limit orders are used most frequently. A buyer or seller of conventional mutual fund shares trades with the fund at a price linked to the fund's next net asset value (NAV) calculation (usually based on each day's market closing value of the fund's portfolio). Any order to buy or sell shares of a conventional fund is the rough equivalent of a market-on-close order. Limit orders or other types of orders are not accepted by conventional funds. Individual ETF shares cannot be purchased from the fund and are not redeemable in a trade with the fund. ETF shares must be created and redeemed in what are called Creation Unit Aggregations, commonly from 20,000 to 100,000 fund shares per unit.
Individual ETF shares cannot be purchased from the fund and are not redeemable in a trade with the fund. ETF shares must be created and redeemed in what are called Creation Unit Aggregations, commonly from 20,000 to 100,000 fund shares per unit.
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3. How are new ETF shares created and how are the shares redeemed?
In a creation transaction, each ETF will issue new fund shares in Creation Unit Aggregations to Authorized Participants (broker dealers and other large investors that have signed a Participation Agreement with a fund’s Distributor) who pay for new shares by depositing portfolios of securities designated by the fund that closely resemble the fund's portfolio. Redemption occurs in much the same manner in reverse. To make a redemption, an Authorized Participant assembles the number of fund shares in a Creation Unit Aggregation or a multiple of that number of fund shares and exchanges the fund shares for a basket of securities from the fund portfolio.
The in-kind creation and redemption mechanism has a number of purposes. In-kind transactions do a fairer job of allocating transaction costs among different types of shareholders than the conventional mutual fund cash purchase and redemption process. An investor who buys ETF shares and holds them may pay a larger initial transaction cost than the buyer of conventional mutual fund shares, but ongoing shareholders in an ETF will be protected from some tax and transaction costs caused by shareholders entering and leaving a conventional fund. These costs can be a major drain on the performance of conventional funds, especially actively-managed funds. Investors who buy or sell ETF shares in less than Creation Unit Aggregations depend on arbitrage forces in the market to keep the intra-day price of the ETF shares very close to the per fund share value of the underlying portfolio.
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4. What kinds of investors typically find ETFs more attractive than conventional mutual funds? ETFs are usually most attractive to:
- long-term investors who value the ETF's lower operating costs and/or its ability to defer some capital gains tax payments until the investor sells the shares;
- short-term traders who want to trade intra-day rather than at the close or who find their trading is discouraged by conventional funds;
- investors who value the greater transparency of ETFs which usually publish any portfolio changes daily; and
- investors who are concerned that many conventional mutual funds do not adequately protect ongoing investors from active fund share traders and market timers.
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5. What kinds of investors typically find ETFs less attractive than conventional mutual funds?ETFs are usually less attractive to:
- investors who make small periodic investments and who benefit from the conventional no-load mutual fund purchase and sale process with its absence of a trading spread and commission charge;
- traders who are willing to trade only at the Fund's net asset value (rather than at intra-day prices) and who would save more money by not paying commission charges and a market spread when they buy and sell fund shares than they would pay in higher expenses within the fund over the period they hold the shares;
- investors who take comfort from the availability of redemption at net asset value who may be concerned that the ETF shares are not individually redeemable at NAV, making the shareholder dependent on market efficiency to ensure fair pricing for redemption; and
- active fund share traders who can trade conventional mutual fund shares at each day’s close at NAV with their trading costs shifted to the fund’s ongoing shareholders.
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6. Are ETFs better than conventional mutual funds?
Each investor should evaluate the characteristics and costs of specific ETFs and competitive conventional mutual funds from a personal perspective to reach a decision on which fund is best. We would observe that the Investment Company Institute reports that as of June 30, 2007, there were only 526 ETFs listed for trading in the United States with total assets of $486 billion. In contrast, there were 8,023 mutual funds with total assets of $11,390 billion. However, since the introduction of ETFs in 1993, assets in ETFs have grown much faster than conventional mutual fund assets.
ETFs and conventional mutual funds have many features in common. Both invest their assets in portfolios of securities. Each offers shares which can be bought and sold in relatively small transactions, permitting a small investor to obtain relatively low cost diversification, spreading risk over a number of underlying companies and markets.
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7. What are the costs associated with Mutual Funds and Exchange-Traded Funds?
Costs that should be fully disclosed by all funds (Expense ratio items)
- Management fee
- Other fund expenses
- Custody (safekeeping)
- Transfer agency
- Securities processing
- DTCC fees
- Income collection
- Wire charges
- Fund administration
- Fund accounting
- Auditing
- Tax return preparation
- Out-of-pocket expenses of service providers
- Reports to regulators and shareholders
- Index license fees (if applicable)
- Marketing expense items paid by fund (12(b)1 fees)
Portfolio income and expenses not always reported clearly
Commissions and other direct transaction charges (including “soft dollar” premiums) usually buried in fund performance
Securities lending revenue and expenses (net revenue may be buried as a credit in the expense ratio)
Earnings credits on balances, interest on overdrafts (usually net revenue or expense is buried in the expense ratio)
Economic costs that may not have an accounting counterpart (Reflected in Performance)
- Non-commission transaction costs
- Trading (bid-asked) spreads
- Market Impact
- Opportunity costs
- Transaction costs embedded in index changes
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8. Who Pays Various Fund Costs?
Conventional No-Load Mutual Funds
- All costs of providing liquidity to entering and leaving shareholders are ultimately paid by ongoing fund shareholders
- Some marketing costs are covered by the management fee
Conventional Load Mutual Funds
- Marketing costs usually paid by entering (occasionally by leaving) shareholders or by management company
- All other costs, including the costs of providing liquidity to entering and leaving shareholders, are ultimately paid by ongoing fund shareholders
Exchange-Traded Funds
- Fully disclosed expenses are paid by fund shareholders except some sales/ redemption costs which are paid directly by Authorized Participants and passed on to fund share traders
- Portfolio expenses and economic costs from sales and redemptions are paid by Authorized Participants and passed on to fund share traders
- Other portfolio expenses and economics costs are, appropriately, borne by ongoing shareholders.
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