An X-Ray of How Exchange-Traded Funds Work
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The ever increasing popularity of exchange-traded funds (ETFs) has made a significant impact on how investors seek returns through the use of packaged investment products.
The list of benefits ETFs offers include transparent portfolio and strategy, ability to trade during market hours, ability to sell short, some ETFs have put and call options, reduced management expenses, and improved tax efficiency tend to drive more investors and professional advisors to employ ETFs. Strategies that use ETFs tend to be based on the premise that an ETF is benchmarked to an index and that an allocation to that index allows a performance guideline to be established.
The benchmarking process seems to be quite normal. In everyday life individual comparisons are generally made to a peer group. However in the ETF world, numerous providers of these investment products create the benchmark first then build the ETF around it. There are occasions when such benchmark are produced from hypothetical data and then at the inception of an ETF all of a sudden becomes a real time measurement. This seems to be a tail wagging the dog event.
Further introspection of ETFs should take a close look at the internal structure. The format of the structure has a significant bearing on the investment vehicles that are used to mimic the benchmark. These structures include the following; open-end funds, Unit of Investment Trusts (UITs), Grantor Trust, Limited Partnerships (LPs), and Exchange-Traded Notes.
Most ETFs fall in the open-end fund category. This design enable the greatest flexibility by the allowing the use of derivatives, securities lending, and portfolio sampling. Open-end funds offer greater tax efficiency, except when the underlying asset is tax inefficient and its properties affect this characteristic. The iShares Barclays TIPS Bond (NYSEMKT:TIP) falls into this category.
Unit of Investment trusts are far more restrictive. UITs are generally designed to have a specific life span and the portfolio is fixed at inception. When the underlying assets receive interest or dividends, distributions are made to the share and no provision for reinvesting these cash flows exists. UITs are not allowed to engage in securities lending and derivatives that are ties to a portion of the portfolio are also restricted. For example, selling a call option on one the stocks that is held in this structure that is called by the purchaser of the option will be improper application change the portfolio from its original design. The Power Shares QQQ (NASDAQ: QQQ) is an example of this structure.
Grantor Trusts are useful in accommodating single commodity portfolios. An example of
this is the SPDR Gold Shares (NYSEMKT:GLD) which basically purchases and sells physical gold to adjust to supply and demand of investor capital. The physical gold is held in bank vaults at locations that are large enough to house vast quantities of metal and in jurisdictions that are designated in the prospectus. Some single commodity ETFs use a single futures contract as the primary vehicle. This structure adds another degree of complexity. Due to the extreme leverage associated with futures trading, and if the ETF is designed not to use any leverage, adjustments to futures positions is an ongoing process. In addition, futures contracts have a limited life span and at expiration a rollover event occurs and depending on market conditions this may or may not be adverse to the overall performance.
Limited Partnerships are enough structure that use futures contracts. Similar to the Grantor Trust method, with the only exception is the tax through feature of LPs. Gains or losses on futures trading are treated as 60% long-term and 40% short-term. This is regardless of the investor’s holding period and all taxable events will be recorded on a K-1 every year. PowerShares DB Commodity IndexTracking Fund (NYSEMKT:DBC) is an example of this structure.
Exchange-Traded Notes (ETNs) are debt instruments that are linked to the performance of the underlying asset. These introduce the credit risk of the issuer that promises to repay the principal plus interest at maturity. ETNs tend to have a very long maturity and gauging the risk of the issuing bank to repay the principal in 30 years can be difficult. ETNs do not distribute any dividends, interest or capital gains. This helps in the tax efficiency area and that by selling the ETN will gains be recognized. An ETN can be recognized by the issuer, such as Barclay's Bank or JPMorgan. Barclays Long B Leveraged ETN (NYSEMKT: BXUB) meets this definition.
Regardless of structure, it is the Creation and Redemption process of the trustee that balances the portfolio to the ongoing changes of investment capital committed to an ETF. This process is the opposite of traditional mutual fund procedures. Creation units are done at the institutional level where securities are lent to an ETF which in turn uses these units to replicate its portfolio. Redemption Units are basically the return of the stock borrowed from the creation unit. This offsetting event is essentially a return of property and no taxable event occurs. This keeps the tax efficiency of ETFs intact. Furthermore the constant creation and redemption process at the institutional level during trading hours reduces the opportunity to arbitrage stocks held in the creation units and traded at the exchange. Shares placed into the creation unit at one price can have different prices during the day, setting up an opportunity to profit from the price disparity. Without the redemption unit side of the trustee in place, the pricing mismatch could make ETFs far more volatile that what market price action dictates.
As these are some of the internal details on how ETFs operate, the due diligence process of the informed investor should consider these factors as well as how the benchmark was created and the composition of the ETF before committing funds to holding these shares. ETFs have brought to market a new way to invest, yet caution must be exercised before buying something that is hot today and has a strong crowd following.
Jeffrey L. (Jeff) Stouffer is an Investment Advisor Representative and manages the Alexandria VA office of Kingsview Asset Management. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. He can be reached at email@example.com
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