Exchange Traded Funds (ETFs)
Exchange Traded Funds (or ETFs) are essentially Index Funds that are listed on exchanges like stocks. An ETF is a basket of stocks, bonds or commodities that reflect the composition of an index, like S&P 500, FTSE 100 or NSE Sensex. Originally, ETFs were created to track the performance of specific equity indexes. However, newer ETFs also seek to track indexes of fixed income instruments and foreign securities. In addition, newer ETFs include ETFs that are actively managed - that is, they do not merely seek to passively track an index; instead, they seek to achieve a specified investment objective using an active investment strategy.
Certain ETFs are relatively easy to understand. Other ETFs may have unusual investment objectives or use complex investment strategies that may be more difficult to understand and fit into an investor's investment portfolio. For example, "leveraged ETFs" seek to achieve performance equal to a multiple of an index after fees and expenses. These ETFs seek to achieve their investment objective on a daily basis only, potentially making them unsuitable for long term investors.
One thing to keep in mind is that ETFs are not mutual funds. Generally, ETFs combine features of a mutual funds and close-ended funds. Mutual fund units can be bought or sold at the end of day Net Asset Value (NAV) from the mutual fund company. ETFs can only be bought or sold in market transactions, not from a company. The ETF is created by an "ETF Sponsor". The sponsor enters into contractual relationships with one or more financial institutions known as "Authorised Participants". Authorised Participants typically are large broker-dealers. Only Authorised Participants are permitted to purchase and redeem shares directly from the ETF, and they can do so only in large aggregations or blocks (e.g. 50,000 ETF shares) commonly known as "Creation Units".
To purchase shares from an ETF, an Authorised Participant assembles and deposits a designated basket of securities and cash with the fund in exchange for which it receives ETF shares. Once the Authorised Participant receives the ETF shares, it is free to sell them in the secondary market to individual investors, institutions, or market makers in the ETF.
The redemption process is the reverse of the creation process. An Authorised Participant buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the Authorised Participant receives a pre-defined basket of individual securities, or the cash equivalent.
Other investors purchase and sell ETF shares in market transactions at market prices. An ETF's market price typically will be more or less than the fund's NAV per share. This is because the ETF's market price fluctuates during the trading day as a result of a variety of factors, including the underlying prices of the ETF's assets and the demand for the ETF, while the ETF's NAV is the value of the ETF's assets minus its liabilities, as calculated by the ETF at the end of each business day.
Common features between Mutual Funds and ETFs
- Professionally Managed - Both mutual funds and ETFs are managed by registered investment advisers.
- Diversification - Both use diversification as a technique to spread the risk. Spreading investments across a wide range of companies or industry sectors can help lower the risk if a company or sector fails. Many investors find it less expensive to achieve such diversification through ownership of mutual funds or certain ETFs than through ownership of individual stocks and bonds.
- Low Minimum Investment - Both mutual funds and ETFs have very low investment requirement.
- Liquidity and Trading Convenience - Investors of both mutual funds and ETFs can easily redeem their units or shares at market prices. Mutual fund investors can readily redeem their units at the next calculated NAV minus any fees and charges on any business day. ETF investors can trade their ETF shares on the market at any time the market is open.
- Costs despite negative returns - Investors in mutual funds must pay sales charges, annual fees, management fees and other expenses regardless of how the mutual fund performs. Investors may also have to pay taxes on any capital gains. Investors in ETFs must pay brokerage commissions, annual fees, management fees, and other expenses regardles of how ETF performs.
- Lack of Control - Investors in both mutual funds and ETFs cannot directly influence which securities are included in the fund's portfolios.
Some differences between ETFs and Mutual Funds
- Transaction costs - ETF's have low transaction costs compared with mutual funds
- Portfolio Disclosure - Many ETFs will disclose to the public their holdings everyday, while mutual funds will generally disclose their portfolio on a monthly basis.
- Tax Efficiency - ETFs can be more tax efficient than mutual funds because ETF shares generally are redeemable "in-kind". This means that an ETF may deliver specified portfolio securities to Authorised Participants who are redeeming Creation Units instead of selling portfolio securities to meet redemption demands, which could otherwise result in taxable gains to the ETF. Typically, such taxable gains (if not otehrwise offset by the ETF) would be passed through to the retail investors. Mutual funds do not enjoy such tax advantages.
NAV and Intraday Value
An ETF (like a mutual fund) must calculate its NAV (the value of all its assets minus all its liabilities) every business day, which is done typically at the closing price of securities declared by a particular stock exchange.
The ETF is also required to calculate and publish, at frequent intervals on a trading day, an "estimated NAV". This estimated NAV (called the IIV - for Intraday Indicative Value - or IOPV - for intraday operative value - depending on the exchange on which the ETF lists) is unique to ETFs and is based on the estimated value of the ETF's holdings (minus its liabilities) througout the trading day.
Arbitrage is the practice of taking advantage of a price differential between two or more markets. An arbitrage opportunity is inherent in the ETF structure because the ETF's intraday market price fluctuates during the trading day. Due to this fluctuations, the ETF's intraday market price may not equal the ETF's end-of-day NAV. Authorised Participants can arbitrage this difference (and make a profit) because they can trade directly with the ETF at NAV as well as on the market. The expected result of this arbitrage activity is that the market value of the ETF moves back in line with the ETF's NAV per share and investors are able to buy ETF shares on an exchange at a price that is close to the ETF's NAV per share.
Types of ETFs
In general, there are two types of ETFs - Index Based ETFs and Actively Managed ETFs.
Index Based ETFs
Most ETFs trading in the market place are index-based ETFs. These ETFs seek to track a securities index like the S&P 500 stock index or FTSE 100. For example, the SPDR, or "spider" ETF, which seeks to track the S&P 500 stock index, invests in most or all of the equity securities contained in the S&P 500 stock index.
ETF's can also be created to track specific market sectors.
Actively Managed ETFs
Actively managed ETFs are not based on an index. Instead, they seek to achieve a stated investment objective by investing in a portfolio of stocks, bonds and other assets. Unlike with an index-based ETF, the investment manager of an actively managed ETF may actively buy or sell components in the portfolio on a daily basis without regard to conformity with an index.
Actively managed ETFs are required to publish their holdings daily. Because there is no index that can serve as a point of reference for an actively managed funds's holding, publishing the specific holdings allow the arbitrage mechanism to function.
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