[11/4/2014 update: the topic of systemic risk was added to the end of the post. 5/13/2016 update: the risk of Index selection was added to Figure 1 and described as one of the investment risks.]
Exchange-traded funds (ETFs) are popularly known as ‘cheap’ mutual funds. Both types of fund own a pool of investments for the benefit of shareholders, but ETFs offer the advantages of listing their shares in the stock market and charging low trading fees1-4.
Figure 1 illustrates the functional structure of ETFs as interpreted from previously published diagrams1,2 and articles3,4,5.
The core message is that a specialist creates ETF shares in the primary market and sells them to any investor in the stock market. The investor earns profits by collecting dividends from the ETF and reselling the shares for capital gains.
Here’s how it works: The left hand side of figure 1 illustrates the primary market where a large ‘block’ of ETF Shares is created from a Basket of assets (shown by the green arrows) or redeemed for a basket of assets (shown by the red arrows). The ‘block’ –also known as a creation/redemption unit— contains a fixed number of shares. The ETF portfolio holds many baskets of assets, which are collectively called underlying assets. The underlying assets are stocks, bonds, commodities, commodity pools, or currencies depending on the investment strategy of the fund. The specialist –also known as an authorized participant— is a professional broker-dealer who is granted the privilege of trading ETF shares in the primary and secondary markets. Only the specialist can create and redeem the ‘block’ of shares in the primary market.
The right hand side of figure 1 illustrates the secondary market for ETF shares. The secondary market is the stock exchange where ETF shares are listed for trading activity (↔) between the specialist and any number of investors. The ETF shares are only traded for cash in the stock market. Most ETF investments create taxable earnings that are distributed to the shareholders.
On both sides of figure 1, the primary and secondary markets are regulated by the U.S. Securities and Exchange Commission. In the primary market, every share is valued at a constant fraction of the portfolio’s net asset value (NAV). The portfolio’s net asset value is the difference in cash value between its total assets and total liabilities. In the secondary market, every share is valued at a negotiated cash price ($). Both values are typically kept in close proximity by the process of arbitrage (see below).
The Index is published by a financial services company as a separate enterprise and is continually updated to account for fluctuations in market prices of the portfolio’s underlying assets during trading hours. The index provides a benchmark for measuring the portfolio’s net asset value. Most ETFs are index ETFs whose investment goal is to match the fluctuating performance of a selected Index.
The red dots in figure 1 identify four principal sites of investment risk: 1) Index selection, 2) ETF portfolio mismanagement , 3) ETF portfolio low wealth, and 4) Investor tax burden.
The legal structure of the ETF determines its management style, investment strategy and tax consequences4. These functions incur the following investment risks: Index selection- Market indices for U.S. stocks and U.S. bonds are generally less risky than those for commodities, currencies, and derivatives. The established, broad-market indices for stocks (e.g. Dow Jones Industrial Index, S&P 500 Index, Russell 1000) are less risky than the stock market sector indices. Management error- the ETF’s legal structure determines whether its portfolio is managed or unmanaged. Assets in a managed portfolio can be borrowed, lent, or rebalanced and errors in these activities may diminish the value of ETF shares. Low wealth- any ETF with an exceptionally low wealth may be at risk for an early termination and the shareholder is likely to lose profit at liquidation of the fund. Tax burden- shareholders are liable for payment of taxes on ETF earnings. Some ETFs have more complicated tax codes than others based on their legal structure.
A major benefit of investing in an ETF is the frugal diversification achieved by owning shares of the fund. The household investor may choose to purchase any number of shares at one low brokerage fee for each trade. Diversification is achieved by investing in a broad-market ETF or specialty ETF depending on the needs of the investor.
Another big benefit to the household investor is the ability to trade ETF shares at auction price in the stock market during trading hours. By contrast, shares of mutual funds are purchased and redeemed at a net asset value that can only be determined after the closing of stock market trading hours. Thus, the mutual fund’s market value is less transparent than that of the ETF.
Other investment funds
Mutual funds, closed-end funds, and exchange-traded notes operate differently from ETFs:
- Mutual fund shares are not listed in the stock exchange6,7
- Closed-end fund shares are not redeemable8
- ETNs don’t participate in the creation/redemption process5
Arbitrage is the profit-seeking operation used by specialists to capitalize on transient differences between share NAV in the primary market and share price in the secondary market5. Suppose that shares are selling at a considerable premium in the stock market, which means that the market price exceeds NAV by a potentially profitable amount. The specialist uses high-speed trading to form a creation unit at lower NAV and immediately sells the unit at higher price in the stock market. Market forces eventually realign the price and NAV.
Suppose instead that shares are selling at a considerable discount in the stock market, which means that the market price is below NAV by a potentially profitable amount. The high-speed specialist redeems a unit of lower priced shares for a basket of higher valued assets. Market forces eventually realign the share price and NAV.
Arbitrage is beneficial to the ordinary investor by 1) providing a trading opportunity in the stock market, and 2) aligning the share price to share NAV.
At least 80% percent of ETF trading occurs in the secondary market where price corrections are made by an auction process. Less than 20% of the trading occurs in the primary market where malfunctions might disrupt the pricing of ETFs and other securities in the financial system. Potential disruptions of the financial system are called a systemic risk. Three malfunctions of the ETF primary market pose a systemic risk9.
- Illiquidity. The liquidity of underlying assets might not match the liquidity of ETF shares. For example, in the summer of 2013 an announcement by the Federal Reserve caused a massive sale of bonds that lowered the liquidity of bonds and the NAV of bond ETFs. There was a transient drop in prices of the bond ETFs until the auction process corrected the secondary market.
- Specialist failure. The specialist might distort the price of an ETF by failing to create or redeem shares. Or, the specialist might go out of business during the settlement period of trading and leave the ETF short of shares. The industry protects against specialist failure by employing many specialists, insuring trades by dealing through a clearing house, and/or requiring the specialist to post collateral.
- Leverage. Index ETFs don’t use borrowed money to manage a portfolio.
The systemic risk of ETFs is judged to be low and reasonably regulated9.
Although the functional structure of ETFs is more complicated than that of mutual funds, ETFs have the reputation of being more tax efficient than mutual funds. ETF investment risks can be evaluated with the use of a scorecard.
Copyright © 2011 Douglas R Knight, updated in 2013 and 2014
VIDEO: What is an ETF
1. BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011. http://www.bis.org/publ/work343.pdf
1B. “Exchange-traded funds. From vanilla to rocky road. The Darwinian evolution of exchange-traded funds”. The Economist, February 25, 2012.
2. Exchange Traded Products- Education. ETF & ETV Activity Flow. ®2011 NYSE Euronext. http://www.nyse.com/about/listed/1266318204137.html
3. SEC Concept Release: Actively Managed Exchange-Traded Funds, SECURITIES AND EXCHANGE COMMISSION, 5/18/2004. http://www.sec.gov/rules/concept/ic-25258.htm
4. Exchange Traded Products- Education. ETFs. ®2011 NYSE Euronext. http://www.nyse.com/about/listed/1266318204096.html
5. Exchange Traded Products- Education. Creation/Redemption process. ®2011 NYSE Euronext. http://www.nyse.com/about/listed/1266405887198.html
6. Mutual Funds. U.S. Securities and Exchange Commission. Modified 12/14/2010. http://www.sec.gov/answers/mutfund.htm
7. ETF Education Center, ETFs vs. Mutual Funds. ©2011 ETFguide.com. http://www.etfguide.com/mutualversusetf.htm
8. Investment company registration and regulation package. U.S. Securities and Exchange Commission. Modified 4/2/2009. http://www.sec.gov/divisions/investment/invcoreg121504.htm
9. Exchange traded funds. Emerging trouble in the future? The Economist, October 25, 2014. http://www.economist.com/news/finance-and-economics/21627717-regulators-are-worried-trendy-new-product-will-sow-instability-emerging