Exchange-Traded Fund (ETF)

Abstract

An exchange-traded fund (ETF) is an investment fund which, like mutual funds, consists of investments in a variety of assets, usually of a specific type. The main feature of ETFs is that, unlike mutual funds, they are listed and traded on stock exchanges. Most ETFs are “unmanaged” or passively managed funds, which track specific financial indexes such as the S&P 500. A small number of actively managed funds have been founded since they were first authorized in 2008, but they pose special challenges and concerns.

Overview

An exchange-traded fund (ETF) is an investment fund consisting of assets such as stocks, bonds, or commodities, which is traded on a stock exchange. They have traits in common with unit investment funds and the more familiar mutual funds, but with the ability to be traded on an exchange. They are attractive to institutional and personal investors because of their low transaction and maintenance costs and relative stability; many ETFs are operated with mechanisms that keep their trading price close to the combined price of the fund’s underlying assets, or net asset value.

ETFs are based on a theoretical model for an “unmanaged investment company,” proposed by economics students Edward Renshaw and Paul Feldstein in 1960. An unmanaged fund, because its investments are predetermined and governed according to external factors, avoids the labor costs and human error of a managed fund, lowering transaction costs. However, the idea did not gain much traction until the 1970s, when it was revived in response to dissatisfaction with mutual funds, which involved higher transaction and management costs but failed to outperform the major indices. Index funds, unmanaged investment funds tracking the major indices, were offered to institutional investors later that decade, beginning with S&P Composite Index Funds offered by American National Bank and Wells Fargo, but it was not until almost twenty years later that tradeable index funds, available to both institutional and personal investors, were made available.

ETFs invest in a variety of tradeable assets, of which stocks are the most common (as with the aforementioned funds founded in the 1970s). They may also invest in bonds, currencies, or commodities. Bond ETFs are attractive to investors because they are essentially recession-proof, or at least significantly more stable and predictable than other assets. However, they also typically yield less of a profit, making the transaction costs proportionately more burdensome.

Commodity ETFs invest in specific commodities, such as gold or other precious metals, energy, petroleum products, or soft commodities. Soft commodities, or “softs,” are commodities that are grown rather than mined—agricultural products like cocoa, livestock (and specific animal products like pork bellies), sugar, or soybeans. The earliest commodity ETFs tracked gold, following the example of the Central Fund of Canada, which had founded as a closed-end fund in 1961 but converted to an ETF investing in both gold and silver in 1983. It was added to the American Stock Exchange (AMEX) in 1986. An ETF investing exclusively in gold launched in 2003 on the Australian Securities Exchange: Gold Bullion Securities, backed by ETF Securities, N. M. Rothschild and Sons, Citibank, and Deutsche Bank. Commodity ETFs differ from stock or bond ETFs in that they purchase tangible, physical items, which therefore must be warehoused somewhere; typically, an annual storage fee is charged in addition to the transaction fees. Soft commodities are stored for only a short period of time, sometimes only long enough to bring them to market. Hard commodities like gold may be stored much longer. In the case of gold ETFs, following the model conceptualized in the early 2000s, the costs of insuring the gold, managing the fund, and other overhead expenses are covered not by a fee to the investor but by selling a small amount of the fund’s gold, such that the total amount of gold declines over time.

One of the advantages of commodity ETFs, particularly those investing in hard commodities, is that in many jurisdictions it represents a significant tax advantage: Buying and selling shares in the ETF are treated as transactions of securities rather than transactions of the underlying assets, and so typically incur a lower tax rate. This is not the case under American law, however, where sales of gold ETF are taxed as though they were sales of gold collectibles, incurring a higher capital gains tax rate than is levied on equity securities. This disadvantage is offset by the fact that American gold ETFs typically charge a lower transaction fee, but it still means that these funds are especially better-suited for long-term and/or institutional investment.

More and more often, commodity ETFs actually operate as commodities futures ETFs, meaning that they do not purchase and take physical possession of the commodity but instead trade in a futures contract. A futures contract—usually just called “futures” in the finance world—is a legal agreement to perform a transaction at a future time, in which both the price of the asset being traded (the forward price) and the time at which the transaction takes place (the delivery date) are specified in advance. It is one of the basic forms of derivatives—a financial product the value of which is derived from an underlying asset.

Currency ETFs were first introduced in 2005, with the Euro Currency Trust. A number of funds track major currencies throughout the world, either singularly like the Euro, or an index of currencies. The MSFX Index Fund, for instance, tracks eighteen different currencies. Profits in foreign currency exchanges are generated by differences in exchange rates as economic developments impact the relative values of currencies to one another. Because of the high volatility of currency, foreign currency is a complicated area of investment, especially for personal investors, and the foreign exchange (forex, or FX) market has traditionally been dominated by institutional investors and banks. Currency ETFs are the most user-friendly form of currency investment for the personal investor.

Applications

ETFs can be differentiated according to the type of assets in which they invest or by the way they are managed. In terms of management, the most common type of ETF is an index fund. Index funds are designed to track a specific index. Tracking here means that the fund’s investments are made according to specified rules that keep them proportional to the assets included in the index. Those assets may be stocks, bonds, commodities, or currency. The best known index fund is the S&P 500 Index Fund, which tracks the S&P 500, an index consisting of five hundred major publicly traded companies. Other index funds use indices of stocks chosen for specific characteristics, such as geography, sustainability, social responsibility, or business sector. Whatever index the ETF is based on, the ETF invests proportionally in the things that make up that index. For instance, the S&P 500 Index Fund invests in all five hundred companies listed by the index.

This type of ETF, first introduced in the United States in 1993 and approved in Europe several years later, is popular because most investors do not manage portfolios that outperform the major indices. It is a generally safe investment: one that increases in value so long as the economy is healthy, though it is subject both to loss of value due to overall economic decline and aberrations either because of the performance of a specific asset in the index or imperfections in the rules used to govern the fund.

The alternative to an index fund (or passively managed fund) is an actively managed ETF. Active management of ETFs has only been authorized by the SEC since 2008, beginning with the Bear Stearns Current Yield ETF. While all the actively managed ETFs that have been approved are fully transparent—meaning that they update their website daily to disclose the securities portfolio currently managed by the fund—the SEC has shown willingness to consider actively managed ETFs that are not fully transparent. Transparency is an advantage to the potential investor, of course, but also makes the fund vulnerable to exploitation in a way that an index fund or less transparent managed fund would not be: By publishing the fund’s activity, the manager’s trading strategy is implicitly revealed, which would allow an outside party to exploit the fund through arbitrage. This kind of exploitation is called “front running” or “tailgating,” terms usually applied to the use of advance inside information. In this case, it is not that the information is unavailable to the public so much as the front runner has used publicly available information to construct inside information about the fund’s trading strategy; a casino analogy might be counting cards, which is considered cheating even though it uses the same information available to other players, without deception or rule breaking. Exploiting the transparency of an actively managed fund, though legal, is damaging and parasitic.

This is primarily a concern for equity ETFs and was originally addressed by trading infrequently—usually on a specific schedule such as once a week or once a month. Debt ETFs are less susceptible to front running, and typically trade more often. Because debt ETFs are less susceptible, many actively managed ETFs are bond funds. There is simply less opportunity for exploitation of this sort on the bond market, where there are fewer choices compared with the vast options of other securities markets and where the products are markedly less volatile.

When actively managed ETFs were introduced, ETFs had been part of the financial landscape for twenty-five years. It is not surprising that actively managed ETFs grew more rapidly after their first introduction than ETFs had; they were a familiar product with a significant but simple-to-grasp difference. Despite that rapid growth, actively managed ETFs are the minority of ETFs by a significant margin. Four years after their introduction, there were only a few dozen actively managed ETFs and more than 1,200 index ETFs.

Issues

There are clusters of types of funds—including ETFs, mutual funds, closed-end funds, and unit investment funds—that are sufficiently similar to one another that it can be helpful to point out the ways in which they differ. Like most mutual funds, ETFs are open-end funds, meaning there is no restriction on the number of shares that can be issued. Typically the manager can make the determination to either close the fund to new investors or close new investment even by current investors; this option is used to prevent the underlying assets from becoming too large and unmanageable. This is in contrast with closed-end funds, which predate ETFs and which issue shares only once.

ETFs are similar enough to mutual funds that some financial services companies will offer two versions of a fund. In such cases, really there is one fund; there are two financial instruments sold, backed by that fund. Shares of the mutual fund are not traded on an exchange, while those of the ETF are. Transaction fees and other fees differ as well, but ultimately, the mutual fund and the ETF perform the same, while meeting slightly different investor needs.

Mutual funds and unit investment funds may be traded only at the end of each trading day. ETFs and closed-end funds are traded throughout the trading day, and their prices vary with respect to their net asset value. ETFs thus combine many of the advantages of mutual funds with the tradability of closed-end funds and the advantages of closed-end funds with the open-endedness of mutual funds.

ETFs were one of the types of securities involved in, and impacted by, the regulatory responses to the “Flash Crash” of 2010. A stock market crash that lasted for 36 minutes on May 6, 2010, the Flash Crash was a trillion-dollar stock market crash, with the Dow Jones experiencing its second-largest intraday loss (that is, a loss experienced after opening) and second-largest point swing. The Flash Crash was eventually found to have been caused in part by trader Navinder Singh Sarao, who was charged with twenty-two criminal counts as a result of his use of spoofing algorithms and front running. The new restrictions on trade (particularly high-frequency trading) after 2010 did not prevent a subsequent, smaller, flash crash in August 2015 (four months after Sarao was charged). The 2015 flash crash principally affected ETFs, which experienced disproportionate volatility with respect to the value of their underlying assets.

Terms & Concepts

Active Management: In contrast with the traditional unmanaged ETF, active management means that a fund’s portfolio is managed by a group or individual making specific investments. Unmanaged funds are sometimes called passively managed funds, for the sake of terminology that is parallel with the increasingly common (but still minority) actively managed funds.

Closed-End Fund: Similar to but older than an ETF, a closed-end fund (CEF) is a pooled investment fund overseen by a manager and traded like stock on an exchange. Unlike ETFs and most mutual funds, closed-end funds issue a fixed number of shares, which may be traded but which do not increase in number.

Commodity Market: A financial market that trades in goods from the primary sector—that is, goods that are produced either through mining (“hard” commodities like precious metals and petroleum) or agriculture (“soft” commodities like sugar, coffee, or livestock).

Exchange: A facility for the buying and selling of securities, activities that are limited to credentialed brokers performing transactions on behalf of their clients. Traditionally, exchanges have been physical buildings, the most famous of which is the New York Stock Exchange (NYSE) on New York’s Wall Street, but the majority of trade is now conducted electronically. The only securities that can be traded on any given exchange are those which have been listed there, through procedures and according to criteria that vary somewhat by exchange.

Index: In economics and finance, an index tracks the performance of a group of related economic phenomena. The consumer price index, for instance, measures the price variation in common goods. ETFs are concerned with indices that track tradeable assets such as bonds or stock shares. Some of the best known are the Dow Jones Industrial Average, which tracks the value of thirty specific large publicly traded American companies and is often considered a measure of the country’s overall economic health, and the Standard & Poor 500, which tracks the market capitalization of five hundred companies traded on the NYSE or NASDAQ.

Institutional Investor: A large non-bank organization trading securities in large quantities. Institutional investors receive preferential treatment, pay lower transaction costs, and often have access to investments or services not offered to personal investors. While the terminology implies investment by an organization, an individual may qualify to be treated as an institutional investor if they have sufficient resources.

Security: A security is a negotiable financial instrument representing stake in ownership or creditorship. For instance, a bond is a security representing a debt owed to the creditor by a public- or private-sector body, and a share of stock represents a percentage of ownership in a publicly traded corporation. Securities representing creditorship are called debt securities; those representing ownership, equity securities. Securities can be bought and sold on various exchanges.

Unit Investment Trust (UIT): A unit investment trust is an investment company offering investors a fixed portfolio of securities, usually for the purpose of providing dividend income.

Bibliography

Alexopoulos, T. A. (2018). To trust or not to trust? A comparative study of conventional and clean energy exchange-traded funds. Energy Economics, 72, 97–107. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=129973204&site=ehost-live

Farinella, J., & Kubicki, R. (2018). The performance of exchange traded funds and mutual funds. Journal of Accounting & Finance (2158–3625), 18(4), 44–55. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=131818083&site=ehost-live

Hu, H. T. C., & Morle, J. D. (2018). A regulatory framework for exchange-traded funds. Southern California Law Review, 91(5), 839–942. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=132554465&site=ehost-live

Kumar, K. S. (2018). A study on pricing efficiency and replication strategy of exchange traded funds. SDMIMD Journal of Management, 9(2), 1–8. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=132888741&site=ehost-live

Lettau, M., & Madhavan, A. (2018). Exchange-traded funds 101 for economists. Journal of Economic Perspectives, 32(1), 135–154. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=127676950&site=ehost-live

Ma, J. Z., Ho, K.-C., Yang, L., & Chu, C.-C. (2018). Market sentiment and investor overreaction: Evidence from New York listed Asian country exchange traded funds. Emerging Markets Finance & Trade, 54(11), 2455–2471. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=130693845&site=ehost-live

March-Dallas, S., Daigler, R., Mishra, S., & Prakash, A. (2018). Exchange traded funds: Leverage and liquidity. Applied Economics, 50(37), 4054–4073. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=130125706&site=ehost-live

Santhosh, A. (2018). A comparative analysis of trading in exchange traded funds of the same fund houses. CLEAR International Journal of Research in Commerce & Management, 9(4), 34–38. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=129940603&site=ehost-live

Stadulis, L. P. (2018). The regulation of mutual fund and exchange traded fund research reports under the SEC’s proposed FAIR Act implementation rules. Investment Lawyer, 25(8), 7–18. Retrieved December 15, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=131198080&site=ehost-live

Suggested Reading

Huang, N. S. (2018). ETFs with star power. Kiplinger’s Personal Finance, 72(9), 50–56. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=130895187&site=ehost-live

Rompotis, G. G. (2018). Herding behavior among exchange-traded funds. Journal of Behavioral Finance, 19(4), 483–497. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=132902530&site=ehost-live

Wallace, D., & McIver, R. (2019). The effects of environmental announcements on exchange traded funds. Emerging Markets Finance & Trade, 55(2), 289–307. Retrieved December 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=133200065&site=ehost-live