Exchange-Traded Funds (ETFs)

ETFs combine features of mutual funds and individual stocks. They offer diversification like mutual funds but trade on exchanges throughout the day like stocks. ETFs have grown dramatically in popularity due to their low costs, tax efficiency, and trading flexibility.

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ETF Characteristics

Trading Features

Structure

Most ETFs are registered as either:

• Open-end management companies (most common)
• Unit investment trusts (older ETFs like SPDR S&P 500)

ETFs hold a basket of securities (stocks, bonds, commodities) and issue shares representing ownership in that basket.

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The Creation/Redemption Mechanism

ETFs use a unique process involving Authorized Participants (APs) that keeps prices close to NAV and provides tax efficiency.

How It Works

Creation Process:

1. AP assembles basket of underlying securities
2. AP delivers securities to ETF sponsor
3. ETF sponsor issues new ETF shares to AP
4. AP sells ETF shares on exchange

Redemption Process:

1. AP purchases ETF shares on exchange
2. AP delivers ETF shares to ETF sponsor
3. ETF sponsor delivers underlying securities to AP
4. AP sells securities in the market

Authorized Participants

In Practice

If an ETF trades at a premium to NAV, APs can profit by:

1. Creating new ETF shares (deliver cheap basket, receive expensive ETF shares)
2. Selling ETF shares on exchange
3. This creation increases supply and pushes ETF price down toward NAV

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ETF Tax Efficiency

ETFs are generally more tax-efficient than mutual funds due to the in-kind creation/redemption process.

Why ETFs Are Tax-Efficient

Mutual Fund Tax Disadvantage

When mutual fund investors redeem shares:

1. Fund must sell securities to raise cash
2. Selling triggers capital gains
3. ALL shareholders receive taxable distribution
4. Even investors who didn't redeem owe taxes

On the Exam

The key to ETF tax efficiency is the in-kind creation/redemption process. When an AP redeems ETF shares, they receive the actual securities—not cash. Since no securities are sold, no capital gains are realized.

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Types of ETFs

Index ETFs (Most Common)

Sector and Industry ETFs

Focus on specific sectors with higher concentration risk:

• Technology (XLK, VGT)
• Healthcare (XLV, VHT)
• Financials (XLF, VFH)
• Energy (XLE, VDE)

Specialty ETFs

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Leveraged and Inverse ETFs

These products require special understanding due to their unique risks.

Daily Reset Problem

Leveraged and inverse ETFs reset daily, which causes compounding decay over longer holding periods.

Example: 2x Leveraged ETF Over 2 Days

The index returned to $100 (0% total), but the 2x ETF lost $1.82 (−1.82%)!

Suitability Concerns

On the Exam

Leveraged and inverse ETFs are designed for short-term trading only. Due to daily resetting and compounding effects, holding them long-term can result in significant deviation from expected returns.

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ETFs vs. Mutual Funds: Complete Comparison

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Key Takeaways

• ETFs trade on exchanges throughout the day at market prices that may differ from NAV
• Authorized Participants create and redeem ETF shares, keeping prices close to NAV
• In-kind redemptions make ETFs more tax-efficient than mutual funds
• ETFs generally have lower expense ratios than actively managed mutual funds
• Leveraged and inverse ETFs reset daily and are NOT suitable for long-term holding
• ETFs can be sold short and bought on margin, unlike mutual funds