Exchange Traded Funds (ETFs)

What are ETFs?

ETFs, or Exchange Traded Funds, are pooled investment vehicles for which the shares of the fund are available for trading over an exchange. ETFs typically adopt a passive investment style, have very low fees compared to actively managed funds, and are designed to have the beneficial features of both mutual funds and closed-end investment companies.

Investors may seek an EFT as a low-cost way of getting exposure to market movements. They may use them as standalone investments or as part of hedging or other investment strategies.

ETF vs. Mutual Funds Comparison

ETFs can help combine the best features of mutual funds and closed-end investment companies. Mutual funds are open-ended and can accept new money from investors, while closed-ended investment companies issue a pre-determined number of shares that can be traded on an exchange.

ETFs are open-ended and can be traded at any time during the day at a variable price. When an investor buys into an EFT, new shares are created. These are then redeemed when the fund shares are sold. ETFs tend to have lower expense ratios than mutual funds, but incur brokerage costs when trading in and out of ETFs. Mutual funds, on the other hand, often involve trading directly with the mutual fund company, sometimes with minimal or no trading costs.

Types of ETFs

The most common types of ETFs are:

• Equity ETFs – tracks stock indices such as the S&P500
• Bond/Fixed Income ETFs – these funds look at both corporate and government bonds
• Commodity ETFs – covers hard commodities such as oil, gold and gas, but there are also funds for soft commodities including agriculture, both physicals and futures pricing
• Currency ETFs – currency funds look at the main global currencies or can be specific to a region
• Specialty ETFs – also known as thematic EFTs, these funds will look at specific investment themes such as clean energy, AI or cryptocurrency
• Sustainable ETFs – will focus on sustainable investments
• Factor ETFs – these funds will have a specific focus such as value, growth or momentum investments and are typically equity based

These funds all provide investors with a specific exposure to the markets. ETFs can be passive (i.e. diversified and typically with similar holdings to an index), or they can be more actively managed to try and achieve the best returns possible.

ETF Tax Efficiency Strategies

One of the main benefits of ETFs is that there are generally fewer taxable gain distributions due to their unique redemption process. Investors are generally trading with themselves, so there is no impact or sale of underlying holdings within the ETF. ETFs are tax-efficient due to the in-kind creation process, which allows the fund to create or cancel shares without needing to purchase or sell securities. This process reduces the need for the fund to realize capital gains, making ETFs more tax-efficient compared to traditional mutual funds.

ETF Portfolio

An ETF portfolio is created through the ‘in-kind’ creation process, where a portfolio of securities is delivered to the fund in exchange for shares in the ETF. This process allows the fund to create or cancel shares at any time without needing to purchase or sell securities.

In-Kind Creation Process

ETFs can be traded on an exchange throughout the trading day due to the way in which the fund creates or redeems investments in the fund. For traditional mutual funds, there is only one time per day when the fund accepts new investments or permits withdrawals from the fund to reduce the need for the mutual fund manager to have to trade on behalf of the fund to invest new money, or sell investments from the fund to meet withdrawals.

In contrast to this, an ETF does not accept money in exchange for new shares in the fund. Instead, the fund must be provided with a portfolio of securities that matches the existing assets held by the fund. The same is true in reverse if the ETF shares are being sold back to the fund. This process is referred to as the ‘in-kind creation’ process and has the benefit of the fund not needing to purchase or sell securities in response to investments in or withdrawals from the fund. The fund is able to create or cancel shares in the ETF at any time through the day without any detriment to the fund.

However, the ‘in-kind’ creation process is not the way in which most investors will invest in an ETF. The ETF is responsible for appointing an ‘authorized participant’ (AP), who may be a stockbroker, investment bank or other large financial institution, to trade with the ETF to effect this in-kind creation process. Once the shares have been issued to the AP they can then be traded by the AP over an exchange with any investor, or can be traded between investors, just like any other listed security.

The AP will trade with the ETF when there is a mismatch between the value of the ETF shares on the exchange and the NAV of the ETF itself. Higher levels of demand for the ETF shares by investors will drive their price higher than the NAV, which will then trigger the AP to deliver the required portfolio of assets to the fund in exchange for more ETF shares. These shares will then be sold by the AP over the exchange, increasing supply and therefore returning the price of the ETFs back down towards the NAV.

ETF Net Asset Value (NAV)

The Net Asset Value (NAV) of an ETF is calculated as the sum of all its assets minus liabilities divided by the number of outstanding shares.

The NAV is provided daily and is a crucial data point for ETFs.

ETF Market Price vs. NAV

An ETF’s market price can differ from its NAV due to supply and demand dynamics. Higher levels of demand for ETF shares will drive their price higher than the NAV, which will then trigger the authorized participant (AP) to deliver the required portfolio of assets to the fund in exchange for more ETF shares, increasing supply and returning the price of the ETFs back down towards the NAV.

The assets represent the value of the ETF’s holdings in assets including cash, stocks, bonds, financial derivatives, and other securities.

Here is the formula for NAV, which is essentially the value of assets minus liabilities divided by the number of shares outstanding.

NAV = Sum (Value of Assets – Value of Liabilities) / No. of Shares Outstanding

The NAV of an ETF is a reference point for investors, which they can use to assess offers to purchase or sell shares of the ETF. It is also used to measure the performance of ETFs.

ETFs Trading on a Premium or Discount

An ETF is said to be trading at a premium (discount), when its market price is higher (lower) than its NAV. Typically, the premium (discount) between an ETFs NAV and its market price arises due to late market activity. However, most premium (discount) patterns for an ETF do not last long, i.e. they are short-lived and will narrow on the following open.

In the case of ETF’s, a fund’s NAV can be different from its market price (the market price is the price at which investors can buy or sell shares of an ETF). This is because the dynamics of supply and demand come into play in the case of ETF’s, which can result in driving the market price higher or lower than an ETF’s net asset value. However, usually the market price per share of an ETF tends to be quite close to its NAV per share.

Exchange Traded Funds, NAV – Example

Let’s assume that an ETF has $12 million in securities (i.e., this is the market value of all securities), $4 million in cash, and $2 million in liabilities. Further, assume that the ETF has 2 million shares outstanding. Using the formula above, the NAV of the ETF (per share) is calculated below:

The NAV for this ETF is $7/share.

Access the free Financial Edge template to assist in calculating NAV for exchange-traded funds.

Passive vs Active ETFs

Historically, ETFs have typically been index funds, but this has changed recently with more active managers entering the ETF space. Closed-ended mutual funds were predominantly actively-managed stock or bond funds, whereas ETFs were typically passive index instruments.

Passive Investments

The majority of ETFs are passively managed investment funds, due to the in-kind creation process. For the AP to know which assets to deliver through the in-kind creation process, they must know what assets are held by the fund. There is a requirement for holdings of an ETF to be made public daily.

The publication of the assets held by a fund, and their associated weights, is not something that most active managers would be willing to do, as it would reveal their investment strategy, allowing anyone else to match their holdings, without having to pay a fee to the actively managed fund. ETFs are generally passively managed, since there is no competitive advantage lost through the daily publication of their holdings.

Active Investments

Actively managed ETFs do exist, but they are in the minority.  Some are fully transparent and publish their holdings daily, typically bond ETFs where the lower liquidity of many corporate bonds makes it harder for other investors to replicate the fund’s holdings. Others have approval from the SEC to operate on a semi-transparent basis, the legal structure of which takes many different forms.

Conclusion

Exchange Traded Funds (ETFs) offer a range of benefits that make them an attractive investment option. Their tax efficiency, due to the unique redemption process, results in fewer taxable gain distributions. The ability to trade intraday provides flexibility for investors, while lower expense ratios make them a cost-effective choice.

ETFs also offer diversification by pooling together a variety of assets, and their transparency allows investors to know exactly what assets are held by the fund. These advantages, combined with the accessibility of ETFs, make them a popular choice for investors looking for a flexible, cost-effective, and tax-efficient investment option. Whether you are a seasoned investor or just starting, ETFs can be a valuable addition to your investment portfolio.