WHAT IS AN ETF?

ETFs (exchange-traded funds) have existed for 20 years yet many people still are not familiar with them which is why I get asked the “What is an ETF?” question yet.  Let me try to offer some clarity.

Before I get started I would like to remind you that an ‘index’ is a collection of stocks or bonds that represent a specific sector of the economy.  One cannot invest in an index.  For instance, the S&P 500 index is made up of 500 stocks representing the most actively traded securities which include 500 of the largest U.S. companies.

ETFs are funds that invest in a portfolio of securities that track a corresponding index.  The first ETF— tracking the S&P 500 index — was the SPDR Ticker: SPY that was introduced in 1993.  Other ETFs tracking popular indexes soon followed.  Up until 2008, index-based ETFs were required to track the performance of specified indexes or a multiple of, or an inverse of, the benchmark index performance.  To help clarify, let’s look at some examples.

The SPY ETF Tracks the S&P 500

An ETF created to track the S&P 500 index is SPY. The performance in the chart below includes reinvested dividends.  What I call the ‘traditional’ ETF is a passive investment designed to replicate the performance of an index with no attempt to outperform it.

Source: Morningstar Advisor

Types of ETFs

ETFs that track a multiple of, or an inverse of, the benchmark index are generally considered ‘trading’ ETFs because they seek to deliver a specific performance over a one-day period of time.

A leveraged ETF seeks to deliver multiples of the performance of the index or benchmark.

• If the ETF promise is for 2X the index performance, then if the corresponding index rises 2% during the day, the ETF will increase twice that amount or 4%.  Visa versa, if the index falls 2% the ETF will decline by 4%.

An inverse ETF seeks to deliver the opposite return of the index.  This is called a ‘short’ ETF.

• The index performance is -2%, then the inverse ETF seeks to rise by 2%.  The opposite would occur if the index was up 2%, the ETF would decline by 2%.
• One can also buy an ‘ultrashort’ ETF.  This type of ETF seeks to achieve a daily return that is opposite that of the index by some multiple.  For example an ETF promising -2X return of the index would increase 4% when the index return is -2%.  The opposite would also be true, if the index increased 2%, the ETF would fall by 4%.

In 2008, the first ‘actively managed’ ETF was created. Actively managed ETFs do not seek to track the return of a particular index. Instead, it creates a unique mix of investments to meet an investment objective and policy.

Why are ETFs gaining in popularity?

Since their inception in 1993, the number of ETF funds has grown to over 1,300 funds, holding $1.5 trillion in assets.  Exchange-traded funds have some advantages over actively managed mutual funds that have drawn the interest of investors over the past 20 years.  The following attributes have endeared them to both institutional and individual investors.

• They trade throughout the day. Retail investors buy and sell ETF shares on a stock exchange through a broker-dealer, much like they would any other type of stock. Unlike traditional mutual fund shares that are priced the same for all investors at the end of the day.
• ETFs generally incur lower costs. Because most ETFs are passively managed, it charges fewer administrative costs than actively managed portfolios. Typical ETF administrative costs are less than 0.20% per year, as opposed to the over 1% yearly cost of some mutual funds.
• Tax efficiency is an ETF benefit.  An ETF is created through a unique creation/redemption process, allowing the fund to avoid capturing and distributing most capital gains to share owners.  This is unlike mutual funds that may capture capital gains to meet redemptions and distribute those gains to all share owners who may or may not have been sellers of fund shares.
• Because most ETFs are passively managed their transactions take place only to keep pace with changes in the corresponding index.  An index generally rebalances quarterly or annually.  Therefore, transaction costs are low relative to an actively managed mutual fund that trades regularly in an attempt to outperform its benchmark index.
• Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies – because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market.

For more information on ETFs here are some excellent websites for you:

http://www.indexuniverse.com/

http://morningstar.com/

http://etfdb.com/

http://xtf.com/

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