What exactly is an ETF?
This is the first in a series of 3 educational e-mails relating to Thursday Night’s ETF Trading seminar for long term investors.
Let’s first look at what exactly an ETF is…
An ETF is an Exchange Traded Fund.
According to the ETF Zone…
ETFs are securities certificates that state legal right of ownership over part of a basket of individual stock certificates.
Several different kinds of financial firms are needed for ETFs to come into being, trade at prices that closely match their underlying assets, and unwind when investors no longer want them. Laying all the groundwork is the fund manager.
This is the main backer behind any ETF, and they must submit a detailed plan for how the ETF will operate to be given permission by the SEC to proceed.
In theory all that a fund manager needs to do is establish clear procedures and describe precisely the composition of the ETF (which changes infrequently) to the other firms involved in ETF creation and redemption.
In practice, however, only the very biggest institutional money management firms with experience in indexing tend to play this role, such as The Vanguard Group and Barclays Global Investors.
They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks necessary for the creation process.
They also create demand by lining up customers, either institutional or retail, to buy a newly introduced ETF.
The creation of an ETF officially begins with an authorized participant, also referred to as a market maker or specialist.
Highly scrutinized for their integrity and operational competence, these middlemen assemble the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping.
These baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in question.
The custodial bank doublechecks that the basket represents the requested ETF and forwards the ETF shares on to the authorized participant.
This is a so-called in-kind trade of essentially equivalent items that does not trigger capital gains for investors.
The custodial bank holds the basket of stocks in the fund’s account for the fund manager to monitor.
There isn’t too much activity in these accounts, but some cash comes into them for dividends and there are a variety of oversight tasks to perform. Some managers have leeway to use derivatives to track an index.
This flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the same US government agency that records individual stock sales and keeps the official record of these transactions. It records ETF transfer of title just like any stock.
It provides an extra layer of assurance against fraud.
Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open market. From then on ETF shares are sold and resold freely among investors on the open market.
Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open market and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks which are then sold on the open market or typically returned to their loanees.
What motivates each player?
The fund manager takes a small portion of the fund’s annual assets as their fee, clearly stated in the prospectus available to all investors.
The investors who loan stocks to make up a basket make a small interest fee for the favor.
The custodial bank makes a small portion of assets likewise, usually paid for by the fund manager out of management fees.
The authorized participant is primarily driven by profits from the difference in price between the basket of stocks and the ETF and on part of the bid-ask spread of the ETF itself.
Whenever there is an opportunity to earn a little by buying one and selling the other, the authorized participant will jump in.
The process might seem cumbersome but it does allow for transparency and liquidity at modest cost.
Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that they can exit at any time, and even the authorized participant’s fees are guaranteed to be modest.
If one allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step in and take profit on the difference, so their competition tends to keep ETF prices very close to it underlying Net Asset Value (value of component stocks).
Why Trade ETFs?
ETFs are the most practical vehicle. They help the investor focus on what is most important, choice of asset classes.
All the major stock indexes have ETFs based on them, including:
- Dow Jones Industrial Average
- Standard & Poor’s 500 Index
- Nasdaq Composite
There are ETFs for large US companies, small ones, real estate investment trusts, international stocks, bonds, and even gold.
Pick an asset class that is publicly available and there is a good bet that it is represented by an ETF or will be soon.
Traditional mutual funds take orders during Wall Street trading hours, but the transactions actually occur at the close of the market.
The price they receive is the sum of the closing day prices of all the stocks contained in the fund. Not so for ETFs, which trade instantaneously all day long and allow an investor to lock in a price for the underlying stocks immediately.
ETFs are economical to buy and especially to maintain over the long-run, making them especially attractive for the typical buy-and-hold investor. Annual fees are as low as .09% of assets, which is breathtakingly low compared to the average mutual fund fees of 1.4%.
Although investors must pay a brokerage transaction to purchase them, with discount brokers this becomes negligible with sizable trades. There are a few easy-to-avoid pitfalls to watch out for.
Tax effects are also not to be ignored, and ETFs perform well after-tax.
They can be margined, and options based on them allow for various defensive (or speculative) investing strategies.
Their safety as a securities instrument (considered separately from the safety of any particular asset class they might represent) is considered the same as stock certificates themselves.
Internally, ETFs are far more complex entities than mutual funds.
A fascinating combination of players, including brokers, money managers and market specialists combine to make them run smoothly. Legally, ETFs are a class of mutual fund as they fall under many of the same Securities Exchange Commission rules that traditional mutual funds do. But their different structure means that the SEC has imposed different requirements from traditional mutual funds in how they are bought and sold.
ETFs are index funds at heart, so investors are encouraged to study the philosophy of index investing which downplays stock picking in favor of buying the market.
But unlike most traditional index funds, investors need not take a passive, buy-and-hold approach.
ETFs are also becoming favorites of hedge funds and day traders who like to pull the trigger frequently. Both types of investors may coexist and in fact strengthen each other by lowering overall transaction costs.
Now that you know what an ETF is and how they work…
In our next episode we will look at the various kinds of ETFs…
Index ETFs
Sector ETFs
Currency ETFs
Emerging Markets ETFs and More
We will be discussing an asset allocation strategy to accompany the trading system that we will cover in part 3.
The LIVE Seminar Night event will go deep into the trading system and fully explain the benefits of this disciplined systematic investing technique.
Stay tuned for part 2 tomorrow.
Until tomorrow…
Sincerely,
