Exchange-traded fund

Since most ETFs are index funds, they incur low expense ratios because they are not actively managed. An index fund is much simpler to run, since it does not require security selection, and can be done largely by computer.

Unlike mutual funds, ETFs do not have to buy and sell securities to accommodate shareholder purchases and redemptions. And thus, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses.[13] ETFs typically have extremely low marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.[14]

Over the long term, these cost differences can compound into a noticeable difference. However, some mutual funds are index funds as well and also have very low expense ratios, and some specialty ETFs have high expense ratios.

To the extent a stockbroker charges brokerage commissions, because ETFs trade on stock exchanges, each transaction may be subject to a brokerage commission. In addition, sales of ETFs in the United States are subject to transaction fees that the national securities exchanges must pay to the SEC under section 31 of the Securities Exchange Act of 1934, currently 0.00221% of the net proceeds from the transaction. Mutual funds are not subject to commissions and SEC fees; however, some mutual funds charge front-end or back-end loads, while ETFs do not have loads at all.[15]

ETFs are structured for tax efficiency and can be more attractive tax-wise than mutual funds.

Unless the investment is sold, ETFs generally generate no capital gains taxes, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency compared to mutual funds is further enhanced because ETFs do not have to sell securities to meet investor redemptions.

In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must "distribute" the capital gains to its shareholders and the shareholders must pay capital gains taxes on the amount of the gain (unless such investment is held in an individual retirement account), even if the distribution is reinvested.[16][17] This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. In contrast, ETFs are not redeemed by investors; any investor who wants to liquidate generally would sell the ETF shares on the secondary market, so investors generally only realize capital gains when they sell their own shares for a gain.[18]

In most cases, ETFs are more tax-efficient than mutual funds in the same asset classes or categories.[19]

An exception is some ETFs offered by The Vanguard Group, which are simply a different share class of their mutual funds. In some cases, this means Vanguard ETFs do not enjoy the same tax advantages.[20]

In other cases, Vanguard uses the ETF structure to let the entire fund defer capital gains, benefiting both the ETF holders and mutual fund holders.[21][22][23]

In the United Kingdom, ETFs can be shielded from capital gains tax by investing in them via an Individual Savings Account (ISA) or Self-Invested Personal Pension (SIPP), in the same manner as many other shares. Because UK-resident ETFs would be liable for UK corporation tax on non-UK dividends, most ETFs which hold non-UK companies sold to UK investors are issued in Ireland or Luxembourg.[24][25]

The tax efficiency of ETFs are of no relevance for investors using tax-deferred accounts or investors who are tax-exempt, such as certain nonprofit organizations.[26]

ETF's by Assets (Thousands $)

ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. Also unlike mutual funds, since ETFs are publicly traded securities, investors can execute the same types of trades that they can with a stock, such as limit orders, which allow investors to specify the price points at which they are willing to trade, stop-loss orders, margin buying, hedging strategies, and there is no minimum investment requirement. Because ETFs can be cheaply acquired, held, and disposed of, some investors buy and hold ETFs for asset allocation purposes, while other investors trade ETF shares frequently to hedge risk or implement market timing investment strategies.[27][28]

Options, including put options and call options, can be written or purchased on most ETFs – which is not possible with mutual funds. Covered call strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on call options written against them. There are also ETFs that use the covered call strategy to reduce volatility and simplify the covered call process.[29][30][31]

If they track a broad index, ETFs can provide some level of diversification. Like many mutual funds, ETFs provide an economical way to rebalance portfolio allocations and to invest cash quickly. An index ETF inherently provides diversification across an entire index, which can include broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.

The SEC generally requires ETFs to be transparent and issuers generally are required to publish the composition of the ETF portfolios daily on their websites.[32] However, the SEC does allow certain actively managed ETFs to be non-transparent - i.e. they do not have to disclose exactly what they own.[33][34]

ETFs are priced continuously throughout the trading day and therefore have price transparency.[35]

Most ETFs are index funds that attempt to replicate the performance of a specific index. Indexes may be based on the values of stocks, bonds, commodities, or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.[27]

Many funds track U.S. stock market indexes; for example, Vanguard Total Stock Market ETF (NYSE Arca: VTI) tracks the CRSP U.S. Total Market Index, and ETFs that track the S&P 500 are issued by The Vanguard Group (NYSE Arca: VOO), iShares (NYSE Arca: IVV), and State Street Corporation (NYSE Arca: SPY). Other funds track international stock indexes; for example, Vanguard Total International Stock Index (NYSE Arca: VXUS) tracks the MSCI All Country World ex USA Investable Market Index, while the iShares MSCI EAFE Index (NYSE Arca: EFA) tracks the MSCI EAFE Index, both invest solely in companies that are not based in the United States. Many smaller ETFs use unknown, untested indices.

ETFs replicate indexes and such indexes have varying investment criteria, such as minimum or maximum market capitalization of each holding. For example, the S&P 500 only contains large- and mid-cap stocks, so any ETF that tracks this index will not contain small-capitalization stocks. Others such as iShares Russell 2000 Index replicate an index composed only of small-cap stocks. There are many style ETFs such as iShares Russell 1000 Growth and iShares Russell 1000 Value. The iShares Select Dividend ETF replicates an index of high dividend paying stocks.[36] Other indexes, on which ETFs are based, focus on a specific industry, such as banks or technology, or specific niche areas, such as sustainable energy or environmental, social and corporate governance. They can also focus on stocks in one country or be global.[37]

There are also ETFs, such as Factor ETFs, that use enhanced indexing, which is an attempt to slightly beat the performance of an index using active management.[38]

Exchange-traded funds that invest in bonds are known as bond ETFs.[39] Government bond ETFs thrive during economic recessions because investors sell stocks and buy safer treasury bonds.[40][41]

Bond ETFs generally have much more market liquidity than individual bonds.[42]

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called replication. Other index ETFs such as the Vanguard Total Stock Market Index Fund, use representative sampling, investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. There are various ways the ETF can be weighted, such as equal weighting or revenue weighting.[43][44] For index ETFs that invest in indices with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.[45][46]

Some index ETFs, such as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.

Commodity ETFs invest in commodities such as precious metals, agricultural products, or hydrocarbons such as petroleum. They are similar to ETFs that invest in securities, and trade just like shares; however, because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to review by the U.S. Securities and Exchange Commission (SEC) and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.[47][5]

Commodity ETFs are generally structured as exchange-traded grantor trusts, which gives a direct interest in a fixed portfolio. SPDR Gold Shares, a gold exchange-traded fund, is a grantor trust, and each share represents ownership of one-tenth of an ounce of gold.[48][49]

Most commodity ETFs own the physical commodity. SPDR Gold Shares (NYSE Arca: GLD) owns over 40 million ounces of gold in trust,[50] iShares Silver Trust (NYSE Arca: SLV) owns 18,000 tons of silver,[51] Aberdeen Standard Physical Palladium Shares (NYSE Arca: PALL) owns almost 200,000 ounces of palladium,[52] and Aberdeen Standard Physical Platinum Shares ETF (NYSE Arca: PPLT) owns over 1.1 million ounces of platinum.[53] However, many ETFs such as the United States Oil Fund by United States Commodity Funds (NYSE Arca: USO) only own futures contracts,[54] which may produce quite different results from owning the commodity. In these cases, the funds simply roll the delivery month of the contracts forward from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.[55][56] They can also be index funds tracking commodity indices.

Currency ETFs enable investors to invest in or short any major currency or a basket of currencies. They are issued by Invesco and Deutsche Bank among others. Investors can profit from the foreign exchange spot change, while receiving local institutional interest rates, and a collateral yield.[57]

While most ETFs are index funds, some ETFs, particularly bond ETFs, do have active management.[58]^{: 201–202} Actively managed ETFs are usually fully transparent, publishing their current securities portfolios on their websites daily. But some actively managed ETFs are not fully transparent. A transparent actively managed ETF is at risk from arbitrage activities by people who might engage in front running since the daily portfolio reports can reveal the manager's trading strategy. Some actively managed equity ETFs address this problem by trading only weekly or monthly. Actively managed debt ETFs, which are less susceptible to front-running, trade more frequently.[59]

Actively managed bond ETFs are not at much of a disadvantage to bond market index funds since concerns about disclosing bond holdings are less pronounced and there are fewer product choices.

The largest actively managed ETFs, each bond ETFs with approximately $14 billion in assets, are the JPMorgan Ultra-Short Income ETF (NYSE: JPST), which charges 0.18% in annual fees, and the Pimco Enhanced Short Duration ETF (NYSE: MINT), which charges 0.36% in annual fees.[60]

Actively managed ETFs compete with actively managed mutual funds. While both seek to outperform the market or their benchmark and rely on portfolio managers to choose which stocks and bonds the funds will hold, there are four major ways they differ. Unlike actively managed mutual funds, actively managed ETFs trade on a stock exchange, can be sold short, can be purchased on margin and have a tax-efficient structure. [61][62]

Inverse ETFs are constructed by using various derivatives for the purpose of profiting from a decline in the value of the underlying benchmark or index. It is a similar type of investment to holding several short positions or using a combination of advanced investment strategies to profit from falling prices. Many inverse ETFs use daily futures as their underlying benchmark.[63][64][65][66]

Leveraged exchange-traded funds (LETFs or leveraged ETFs) attempt to achieve daily returns that are a multiple of the returns of the corresponding index.[67] Leveraged index ETFs are often marketed as bull or bear funds. For example, a leveraged bull ETF fund might attempt to achieve daily returns that are 2x or 3x those of the Dow Jones Industrial Average or the S&P 500. A leveraged inverse exchange-traded fund may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market. To achieve these results, the issuers use various financial engineering techniques, including equity swaps, derivatives, futures contracts, and rebalancing, and re-indexing.[68]

Direxion offers leveraged ETFs that attempt to produce 3x the daily result of either investing in (NYSE Arca: SPXL) or shorting (NYSE Arca: SPXS) the S&P 500.[69]

The rebalancing and re-indexing of leveraged ETFs may have considerable costs when markets are volatile. Leveraged ETFs effectively increase exposure ahead of a losing session and decrease exposure ahead of a winning session.[68][70] The rebalancing problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year (1-(1-0.18%)²⁵²=36.5%). Investors may however circumvent this problem by buying or writing futures directly, accepting a varying leverage ratio.[71]^: 12, 90 A more reasonable estimate of daily market changes is 0.5%, which leads to a 2.6% yearly loss of principal in a 3x leveraged fund.

The re-indexing problem of leveraged ETFs stems from the arithmetic effect of volatility of the underlying index.[72] Take, for example, an index that begins at 100 and a 2X fund based on that index that also starts at 100. In a first trading period (for example, a day), the index rises 10% to 110. The 2X fund will then rise 20% to 120. The index then drops back to 100 (a drop of 9.09%), so that it is now even. The drop in the 2X fund will be 18.18% (2*9.09). But 18.18% of 120 is 21.82. This puts the value of the 2X fund at 98.18. Even though the index is unchanged after two trading periods, an investor in the 2X fund would have lost 1.82%. This decline in value can be even greater for inverse funds (leveraged funds with negative multipliers such as -1, -2, or -3). It always occurs when the change in value of the underlying index changes direction. And the decay in value increases with volatility of the underlying index.

The effect of leverage is also reflected in the pricing of options written on leveraged ETFs. In particular, the terminal payoff of a leveraged ETF European/American put or call depends on the realized variance (hence the path) of the underlying index. The impact of leverage ratio can also be observed from the implied volatility surfaces of leveraged ETF options.[73] For instance, the implied volatility curves of inverse leveraged ETFs (with negative multipliers such as -1, -2, or -3) are commonly observed to be increasing in strike, which is characteristically different from the implied volatility smiles or skews seen for index options or non-leveraged ETF options.

In May 2017, the SEC granted approval of two 4x leveraged ETF related to S&P 500 futures, the ForceShares Daily 4X US Market Futures Long Fund, and ForceShares Daily 4X US Market Futures Short Fund, before rescinding the approval a few weeks later.[74][75][76]

In November 2019, the SEC proposed a rule regarding the use of derivatives that would make it easier for leveraged and inverse ETFs to come to market, including eliminating a liquidity rule to cover obligations of derivatives positions, replacing it with a risk management program overseen by a derivatives risk manager.[77] The SEC also proposed rules requiring investors to answer a series of questions before being permitted to invest in leveraged ETFs.[78][79]

Thematic ETFs typically focus on long-term, societal trends, such as disruptive technologies, climate change, or shifting consumer behaviors. Some of the most popular themes include cloud computing, robotics, and electric vehicles, as well as the gig economy, e-commerce, and clean energy.[80] As of June 2019, 13 U.S.-listed thematic ETFs held more than US$1 billion in assets and another nine held more than US$500 million. In Canada, no Canadian-listed thematic ETF holds more than $500 million, with the fund category holding about $2.5 billion as of January 2020.[81]

The first gold exchange-traded product was Central Fund of Canada, a closed-end fund founded in 1961. It amended its articles of incorporation in 1983 to provide investors with a product for ownership of gold and silver bullion. It has been listed on the Toronto Stock Exchange since 1966 and the American Stock Exchange since 1986.[107]

The idea of a gold ETF was first conceptualized by Benchmark Asset Management Company Private Ltd in India, which filed a proposal with the Securities and Exchange Board of India in May 2002. In March 2007 after delays in obtaining regulatory approval.[108] The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. SPDR Gold Shares, a commodity ETF, is in the top 10 largest ETFs by assets under management.[6]

The ETF tracking error is the difference between the returns of the ETF and its reference index or asset. A non-zero tracking error therefore represents a failure to replicate the reference as stated in the ETF prospectus. The tracking error is computed based on the prevailing price of the ETF and its reference. It is different from the premium/discount which is the difference between the ETF's NAV (updated only once a day) and its market price. Tracking errors are more significant when the ETF provider uses strategies other than full replication of the underlying index. Some of the most liquid equity ETFs tend to have better tracking performance because the underlying index is also sufficiently liquid, allowing for full replication.[110] In contrast, some ETFs, such as commodities ETFs and their leveraged ETFs, do not necessarily employ full replication because the physical assets cannot be stored easily or used to create a leveraged exposure, or the reference asset or index is illiquid.[111] Futures-based ETFs may also suffer from negative roll yields, as seen in the VIX futures market.

While tracking errors are generally non-existent for the most popular ETFs, they have existed during periods of market turbulence such as in late 2008 and 2009 and during flash crashes, particularly for ETFs that invest in foreign or emerging-market stocks, future-contracts based commodity indices, and high-yield debt.[112][27] In November 2008, during a period of market turbulence, some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.[113] Per Morgan Stanley, in 2009, ETFs missed their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008.[112]

ETFs have a wide range of liquidity. The most popular ETFs (such as those tracking the S&P 500) are constantly traded, with tens of millions of shares per day changing hands, while others trade in much lower numbers. There are many ETFs that do not trade very often, and thus might be difficult to sell compared to more liquid ETFs. The most active ETFs are very liquid, with high regular trading volume and tight bid-ask spreads (the gap between buyer and seller's prices), and the price thus fluctuates throughout the day. This is in contrast with mutual funds, where all purchases or sales on a given day are executed at the same price at the end of the trading day.

New regulations to force ETFs to be able to manage systemic stresses were put in place following the 2010 flash crash, when prices of ETFs and other stocks and options became volatile, with trading markets spiking and bids falling as low as a penny a share[114] in what the Commodity Futures Trading Commission (CFTC) investigation described as one of the most turbulent periods in the history of financial markets.[115][116]

These regulations proved to be inadequate to protect investors in the August 24, 2015, flash crash,[114] "when the price of many ETFs appeared to come unhinged from their underlying value." ETFs were consequently put under even greater scrutiny by regulators and investors.[114] Analysts at Morningstar, Inc. claimed in December 2015 that "ETFs are a 'digital-age technology' governed by 'Depression-era legislation".[114]

Synthetic ETFs, which do not own securities but track indexes using derivatives and swaps, have raised concern due to lack of transparency in products and increasing complexity; conflicts of interest; and lack of regulatory compliance.[117][118][119]

A synthetic ETF has counterparty risk, because the counterparty is contractually obligated to match the return on the index. The deal is arranged with collateral posted by the swap counterparty. A potential hazard is that the investment bank offering the ETF might post its own collateral, and that collateral could be of dubious quality. Furthermore, the investment bank could use its own trading desk as counterparty. These types of set-ups are not allowed under the European guidelines, Undertakings for Collective Investment in Transferable Securities Directive 2009 (UCITS).[120]

Counterparty risk is also present where the ETF engages in securities lending or total return swaps.[121]

Purchases and sales of commodities by ETFs can significantly affect the price of such commodities.[122][123]

Per the International Monetary Fund, "Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period."[118]

Some critics claim that ETFs can be, and have been, used to manipulate market prices, such as in conjunction with short selling that contributed to the United States bear market of 2007–2009.[124]

Over the years, EDHEC survey results have consistently indicated that ETFs were used as part of a truly passive investment approach, mainly for long-term buy-and-hold investment, rather than tactical allocation. However, over the past three years, the two approaches have gradually become more balanced and, in 2019, European investment professionals declare that their use of ETFs for tactical allocation is actually greater than for long term positions (53% and 51% respectively).

ETFs, which originally replicated broad market indices, are now available in a wide variety of asset classes and a multitude of market sub-segments (sectors, styles, etc.) If gaining broad market exposure remains the main focus of ETFs for 73% of users in 2019, 52% of respondents declare using ETFs to obtain specific sub-segment exposure. The diversity of ETFs increases the possibilities of using ETFs for tactical allocation. Investors can easily increase or decrease their portfolio exposure to a specific style, sector, or factor at lower cost with ETFs. The more volatile the markets are, the more interesting it is to use low cost instruments for tactical allocation, especially that cost is a major criterion for selecting an ETF provider for 88% of respondents.

Despite a high current adoption rate of ETFs and the already high maturity of this market, a high percentage of investors (46%) still plan to increase their use of ETFs in the future, according to the EDHEC 2019 survey responses. Investors are planning to increase their ETF allocation to replace active managers (71% of respondents in 2019), but are also seeking to replace other passive investing products through ETFs (42% of respondents in 2019). Lowering costs is the main motivation for increasing the use of ETFs for 74% of investors. Investors are especially demanding for further developments of ETF products in the area of Ethical/SRI and smart beta equity / factor indices. In 2018, ESG ETFs enjoyed growth of 50%, reaching €9.95bn, with the launch of 36 new products, against just 15 in 2017.[125] However, 31% of the EDHEC 2019 survey respondents still require additional ETF products based on sustainable investment, which appears to be their top concern.

Investors are also demanding for ETFs related to advanced forms of equity indices, namely those based on multi-factor and smart beta indices (30% and 28% of respondents, respectively), and 45% of respondents would like to see further developments in at least one category related to smart beta equity or factor indices (smart beta indices, single-factor indices and multi-factor indices). Consistent with the desire to use ETFs for passive exposure to broad market indices, only 19% of respondents show any interest in future development of actively managed equity ETFs.