Exchange Traded Funds: Mechanics and Applications

We have examined important considerations for ETF investors, including how ETFs work and trade, tax efficient attributes, and key portfolio uses. The following is a summary of key points:

• ETFs rely on a creation/redemption mechanism that allows for the continuous creation and redemption of ETF shares.
• The only investors who can create or redeem new ETF shares are a special group of institutional investors called authorized participants.
• ETFs trade on both the primary market (directly between APs and issuers) and on the secondary markets (exchange-based or OTC trades, such as listed equity).
• End investors trade ETFs on the secondary markets, like stocks.
• Holding period performance deviations (tracking differences) are more useful than the standard deviation of daily return differences (tracking error).
• ETF tracking differences from the index occur for the following reasons:
  fees and expenses,
  representative sampling/optimization,
  use of depositary receipts and other ETFs,
  index changes,
  fund accounting practices,
  regulatory and tax requirements, and
  asset manager operations.
• ETFs are generally taxed in the same manner as the securities they hold, with some nuances:
• ETFs are more tax fair than traditional mutual funds, because portfolio trading is generally not required when money enters or exits an ETF.
• Owing to the creation/redemption process, ETFs can be more tax efficient than mutual funds.
• ETF issuers can redeem out low-cost-basis securities to minimize future taxable gains.
• Local markets have unique ETF taxation issues that should be considered.
• ETF bid–ask spreads vary by trade size and are usually published for smaller trade sizes. They are tightest for ETFs that are very liquid and have continuous two-way order flow. For less liquid
• ETFs, the following factors can determine the quoted bid–ask spread of an ETF trade:
  Creation/redemption costs, brokerage and exchange fees
  Bid–ask spread of underlying securities held by the ETF
  Risk of hedging or carry positions by liquidity provider
  Market makers’ target profit spread
• ETF bid–ask spreads on fixed income relative to equity tend to be wider because the underlying bonds trade in dealer markets and hedging is more difficult. Spreads on ETFs holding international stocks are tightest when the underlying security markets are open for trading.
• ETF premiums and discounts refer to the difference between the exchange price of the ETF and the fund’s calculated NAV, based on the prices of the underlying securities and weighted by the portfolio positions at the start of each trading day. Premiums and discounts can occur because NAVs are based on the last traded prices, which may be observed at a time lag to the ETF price, or because the ETF is more liquid and more reflective of current information and supply and demand than the underlying securities in rapidly changing markets.
• Costs of ETF ownership may be positive or negative and include both explicit and implicit costs. The main components of ETF cost are
  the fund management fee;
  tracking error;
  portfolio turnover;
  trading costs, such as commissions, bid–ask spreads, and premiums/discounts;
  taxable gains/losses; and
  security lending.
• Trading costs are incurred when the position is entered and exited. These one-time costs decrease as a portion of total holding costs over longer holding periods and are a more significant consideration for shorter-term tactical ETF traders.
• Other costs, such as management fees and portfolio turnover, increase as a proportion of overall cost as the investor holding period lengthens. These costs are a more significant consideration for longer-term buy-and-hold investors.
• ETFs are different from exchange-traded notes, although both use the creation/redemption process.
  Exchange-traded notes carry unique counterparty risks of default.
  Swap-based ETFs may carry counterparty risk.
  ETFs, like mutual funds, may lend their securities, creating risk of counterparty default.
  ETF closures can create unexpected tax liabilities.
• ETFs are used for core asset class exposure, multi-asset, dynamic, and tactical strategies based on investment views or changing market conditions; for factor or smart beta strategies with a goal to improve return or modify portfolio risk; and for portfolio efficiency applications, such as rebalancing, liquidity management, completion strategies, and transitions.
• ETFs are useful for investing cash inflows, as well as for raising proceeds to provide for client withdrawals. ETFs are used for rebalancing to target asset class weights and for “completion strategies” to fill a temporary gap in an asset class category, sector, or investment theme or when external managers are underweight. When positions are in transition from one external manager to another, ETFs are often used as the temporary holding and may be used to fund the new manager.
• All types of investors use ETFs to establish low-cost core exposure to asset classes, equity style benchmarks, fixed-income categories, and commodities.
• For more tactical investing, thematic ETFs are used in active portfolio management and represent narrow or niche areas of the equity market not well represented by industry or sector ETFs.
• Systematic, active strategies that use rules-based benchmarks for exposure to such factors as size, value, momentum, quality, or dividend tilts or combinations of these factors are frequently implemented with ETFs.
• Multi-asset and global asset allocation or macro strategies that manage positions dynamically as market conditions change are also areas where ETFs are frequently used.
• Proper utilization requires investors to carefully research and assess the ETF’s index construction methodology, costs, risks, and performance history.