Exchange-Traded Fund: Nature, Developments, and Implications

Abstract

1. The AMEX provides market liquidity and continuous trading at or near current market prices for index shares. Continuous trading provides more flexibility in rebalancing portfolios. Prices are determined by supply and demand. Index shares may be traded in small lots and the trading strategies available to common stock are also available for index shares. 2. Most index shares transactions are executed on the AMEX, especially less than block size trades. Bid-ask spreads are not unreasonable, and brokerage commissions and fees can be reduced by online and/or discount brokers. But, index share trading costs favor buy-and-hold strategies. 3. Large investors may also directly purchase and redeem index shares packaged as minimum block-size creation/redemption units. Creation/redemption units are purchased/redeemed in exchange for stock portfolios that match specific benchmark indexes. But, there are purchase and redemption fees. 4. Investor exchanges of redemption units for in-kind baskets of stock are tax-free exchanges. ETFs do not sell stocks with potential capital gains to meet redemptions and there are no performance drags from holdings of cash assets. Investors may also unbundle portfolio shares received and sell them for any tax losses.5. AMEX trading and tax-free direct exchanges with continuous portfolio transparency facilitate arbitrage that maintains index share prices at or very near NAVs of underlying portfolios. Arbitrageurs buy index shares selling at discount to NAVs on the AMEX, directly exchange redemption units for underlying stock portfolios, and sell unbundled stocks on the AMEX for more than paid for index share redemption units. 6. ETFs are very tax efficient due to direct tax-free exchanges, portfolio transparency, index portfolios, and control over specific composition of underlying stock portfolios. Index portfolios are not actively managed, which minimizes turnover and realized capital gains. Shares of stock with largest unrealized capital gains are exchanged for redemption units to minimize realized capital gains. Shares with smallest unrealized capital gains are sold to meet changes in composition of benchmark indexes and to minimize realized capital gains. 7. Domestic ETFs are inherently less costly to manage than traditional domestic mutual funds. They have lower expense ratios than actively managed domestic mutual funds and also most index funds with the same benchmark indexes.8. ETFs and mutual funds provide instant diversification with broadly based portfolios or homemade portfolios with allocations of narrowly focused ETFs, such as foreign/domestic, specific country, investment style and/or industry sectors.9. ETFs provide access to benchmark indexes and global sectors not (yet) available from mutual funds. 10. Investors may practice cash management by temporarily sweeping cash inflows into index shares. ETFs Disadvantages1. Index share trading costs are higher than pure no-load mutual funds with zero shareholder transaction costs. This difference is increased by market timing and dollar cost averaging strategies that trade frequently, even given online and/or discount brokerage commissions and small bid-ask spreads. 2. Investor purchase and redemption of creation and redemption units are subject to fees, which are higher than for pure no-load mutual funds.3. ETF brokers generally provide less in the way of diversity and quality of shareholder services than mutual funds. 4. ETF index shares risk selling at discounts (also premiums) to NAVs of underlying stock portfolios, but arbitrage normally keeps them small. But, index shares can trade at significant discounts/premiums for extended periods, especially in small, less liquid international markets. HOLDRs have proven to have large discounts to NAV. 5. No sponsor of both EFTs and index mutual funds has yet matched the annual returns of the Vanguard 500 Index Fund. 6. ETFs often have large tracking errors in matching the performance of international small market benchmark indexes. These indexes do not provide required portfolio diversification and markets have low liquidity and high trading costs. Tracking error derives from use of statistical methods to approximate benchmark performance. These ETFs also have higher expense ratios and higher portfolio turnover and trading costs than comparable mutual funds. 7. Performance and liquidity of ETF shares have yet to be severely tested in major market declines. 8. The settlement period for index share trades is three days, but it is overnight for mutual fund redemptions.