Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.

ETF Legal structure

June 19, 2012


Exchange-traded funds (ETFs) are investment companies that list shares in the stock exchange [investment companies collect financial assets from investors, manage an investment portfolio, and issue shares to investors].

The legal structure of ETFs determines their scope of operations.  Most ETFs are designed as an Open-end Investment Company (OEIC) or Unit Investment Trust (UIT) to invest in physical assets classified as ‘securities’, ‘equities’, or ‘bonds’ (open-end refers to a continuous offering of an unlimited number of redeemable shares to the public).   These ETFs may qualify as regulated investment companies for U.S. Federal tax purposes.  Synthetic ETFs are legally structured as Limited Partnerships (LP) or Grantor Trusts (GT) to invest in derivatives of physical assets.  Synthetic ETFs don’t qualify as regulated investment companies.

ETFs that list shares in the United States (U.S.) must register with the U.S. Securities and Exchange Commission (SEC) in compliance with the Investment Company Acts of 1933 and 1940.  The OEIC and UIT are registered under the Investment Company Act of 1940 and all preceding Acts.  OEICs and UITs that are listed in the U.S. stock market must hold at least 80% of the underlying assets in securities relevant to the fund’s name.  By comparison, the LP and GT are registered under the Investment Company Act of 1933 and all preceding Acts.  What follows is a functional characterization of these structures under the broad headings of managed and unmanaged portfolios 1,2.3,4,5.

Managed portfolios

The OEIC and LP operate managed portfolios under the governance of a board of directors.  Both legal structures have these characteristics:

  • Managers may may choose to invest in derivatives, rebalance the portfolio, and lend underlying securities from the portfolio.
  • Shareholders don’t have voting rights to govern firms that issue assets owned by the ETF.

Most OEICs hire an independent investment advisor to invest in a sample of the fund’s strategic index.  The portfolio dividends are reinvested or paid to shareholders on a monthly or quarterly basis 3.  In LPs, the general partners typically manage a portfolio of stable assets in the energy sector 6, although other commodities, securities, and currencies are permissible investments.  All partnership income is passed to the investors, who are called limited partners 3,7.

Unmanaged portfolios

The UIT and GT operate fixed, unmanaged portfolios in compliance with a trust agreement.  The investment portfolios are never rebalanced and the underlying securities are never lent out.  UITs operate a portfolio of securities that replicate a market index.  The portfolio dividends are not reinvested but instead held for quarterly or annual payment to shareholders.  Shareholders are joint owners of the UIT and don’t have voting rights on the underlying securities.  The UIT has an expiration date that is typically extended by the SEC 3,8,9GTs operate a portfolio of securities, commodities, or currencies.  The shareholders are joint owners of the underlying assets and have voting rights on the underlying securities.  GTs don’t generate income and must therefore pay expenses by selling assets.  Shareholders are responsible for the tax consequences 9,10.

Portfolio management error

Managers of OEICs and LPs may rebalance the fund’s portfolio in an attempt to improve fund performance.  The general downside risk of portfolio mismanagement is that dilution of the net asset value diminishes the share price in the stock market in one of several ways.  Firstly, rebalancing the portfolio increases the fund’s expenses.  Secondly, the performance of the rebalanced portfolio may drift from the fund’s investment strategy.   Thirdly, managers may seek to earn more fund income by lending securities to hedge funds and traders who wish to execute investment strategies such as ‘shorting 11,12.  The ETF portfolio benefits by splitting the lending fee with the lending agent.  Some portfolios earn more than others for reasons that include13:

  • Conflict of interest:  Portfolios typically receive less of the lending fee when the lending agent belongs to the same company that operates the Fund.
  • Asset liquidity:  Less frequently traded small cap stocks earn higher lending fees than more frequently traded large cap stocks.

The lending of underlying assets for a fee may create failed trades in the primary market 14,15.  The practice of lending securities is described in the Fund’s schedule of investments and its Form N-Q filing with the SEC.  Fourthly, management’s attempt to hedge the fund’s investments with derivatives (e.g., swaps, repos) may result in the acquisition of collateral assets that have low liquidity.

The legal structure of UITs and GTs does not permit management of the portfolio beyond the terms of the trust agreement, so there is less risk of management error.  These trusts operate a portfolio of fixed composition that is not re-balanced at the discretion of the managers.  Any trusts that receive dividends will make cash distributions to shareholders on a quarterly or annual basis.  “Dividend drag” refers to the shareholder’s potential loss of income due to delayed receipt of the fund’s cash distribution.

Synthetic ETFs

“Synthetic” ETFs (e.g., LPs) use derivatives, not physical assets, to replicate a benchmark index.  The LP can have investment and systemic risks that are hidden by the complexity of the fund’s operations and holdings.  Systemic risk is the risk of collapse of an entire financial market.  One of the systemic risks is “failed trades” 4,11,14,15,16.

Benefits of the ETF legal structure

The ETF legal structure offers two major benefits to investors:

  1. Diversification.  Investors can diversify their investments by selecting fund portfolios according to market region (domestic, foreign) and asset class (securities, commodities, currencies, derivatives).  ETFs that hold securities are considered ‘transparent’ by virtue of the online publication of the portfolio’s intraday net asset value and investment holdings.
  2. Stock market listing.  ETF shares are traded by public auction in the stock market during trading hours.  Traders can devise a number of trading strategies by placing a limit order, stop order, or accepting the current market price 4.

Copyright © 2012 Douglas R. Knight


1.  Investment companies.  U.S. Securities and Exchange Commission, 3/29/2010.  http://www.sec.gov/answers/mfinvco.htm

2.  Investment company registration and regulation package. U.S. Securities and Exchange Commission, 4/2/2009, modified 3/2/2012.  http://www.sec.gov/divisions/investment/invcoreg121504.htm

3.  ETF Education Center, The history of exchange-traded funds.  ©2011 ETFguide.com. http://www.etfguide.com/exchangetradedfunds.htm

4.  BIS Working Papers No 343: Market structures and systemic risks 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

5.  Little, Pat.  Is that an ETF? Research Note, Hammond Associates, September, 2010.

6.  Investing Workbook Series: Stocks 3. How to Refine Your Stock Strategy.  Morningstar, 2005.

7.  Legal structure. http://admainnew.morningstar.com/directhelp/Glossary/Operations/HF/Legal_Structure.htm

8.  Unit Investment Trusts (UITs). U.S. Securities and Exchange Commission, 5/8/2007, http://www.sec.gov/answers/uit.htm

9.  http://www.investopedia.com

10.  USLegal | Definitions.  Copyright © 2001-2012 USLegal Inc. http://definitions.uslegal.com/g/grantor-trust/

11.  Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economisthttp://www.economist.com/node/18864254

12.  Ari L. Weinberg.  Exchange Traded Funds: When ETFs are Lenders. Wall Street Journal, July 6, 2011. http://online.wsj.com/article/SB10001424052702303823104576391573704929238.html?KEYWORDS=when+etfs+are+lenders

13.  Zweig, Jason.  When Funds lend stock, who gains?  The Wall Street Journal, October 22, 2011. http://online.wsj.com/article_email/SB10001424052970203752604576645442999588006-lMyQjAxMTAxMDMwMDEzNDAyWj.html?mod=wsj_share_email

14.  Harold Bradley, Robert Fawles, Robert E. Litan, and Fred Sommers.  Canaries in the Coal Mine. How the Rise in Settlement “Fails” Creates Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation.  http://www.kauffman.org/uploadedfiles/canaries-in-the-coal-mine-report.pdf

15.  Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs).  Financial Stability Board, 12 April 2011. http://www.financialstabilityboard.org/publications/r_110412b.pdf

16.  Exchange-traded funds: A good idea in danger of going bad. The reckless expansion of “synthetic” funds requires a few new rules, June 23rd 2011, The Economist.  http://www.economist.com/node/18867037?story_id=18867037

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