An exchange traded fund (ETF) is technically structured as an open-end management company, but it isn’t a mutual fund. That can feel confusing at first, so here’s the key idea: ETFs are organized like open-end funds, but they trade differently. As the name suggests, ETFs trade on exchanges in the secondary market and are negotiable securities (they trade between investors).
ETFs share many characteristics with open-end and closed-end funds. They purchase and hold securities in a large portfolio on behalf of investors. ETFs have net asset values (NAVs), which reflect the value of the fund’s underlying assets. NAV is calculated once per day based on the closing value of the securities in the portfolio. Because most ETFs hold many securities, you typically get instant diversification by buying just one or a few shares.
The market prices of ETF shares typically follow their NAVs very closely, even though the shares trade in the secondary market*. ETFs can be bought on margin (with borrowed money), sold short, and commissions are involved in their transactions.
*ETF market prices typically match their NAVs due to a feature known as ETF arbitrage. Behind the scenes, institutional investors perform transactions with ETF issuers to push the market price back toward NAV if it deviates. This is a fairly complex process that is unlikely to be encountered on the exam.
ETFs are well known for tracking indexes. For example, one of the most popular ETFs is the S&P 500 “Spyder” ETF. Investors in this ETF make money when the S&P 500 rises and lose money when it falls. This is passive investing: instead of selecting specific stocks, bonds, and other securities, you aim to capture the return of an index.
Indexes track large segments of the market. So when you invest in a passively managed ETF, you’re essentially betting on the “market average” rather than trying to pick the best individual investments.
Research and data exist to support this approach. For example, the Wall Street Journal ran an experiment for many years that involved blindfolding its writers and having them throw darts at lists of stocks. A portfolio was constructed with all of the stocks that the darts landed on. Surprisingly, some of these portfolios performed better than professionally managed funds. A quote from the linked article above:
Over 100 six-month contests, the pros have racked up an average gain of 10.9%, compared with 4.5% for the dart throwers and 6.8% for the Dow industrials. The pros have come out ahead of both the darts and the Dow industrials 44 times.
While the professionals averaged higher than both the Dow Jones Industrial Average* and the dart throwers, they only beat both 44% of the time. Since professional (active) management also involves added costs and fees, results like these are often used to argue for passive management.
*The Dow Jones Industrial Average is a well-known index tracking 30 of the largest US-based stocks.
Active investing is the opposite approach: it focuses on selecting the best investments available (instead of “taking the average”). Active investors (like the professionals in the dart-throwing article) usually measure performance against an applicable index. For example, an active investor in large-cap stocks (stocks of larger companies) would likely compare performance to the S&P 500. If the portfolio outperformed the S&P 500, the investor “beat the market.”
Active strategies try to consistently beat a comparable index, which is difficult to do year after year. According to this CNBC article:
Just 26% of all actively managed funds beat the returns of their index-fund rivals over the decade through December 2021
If you believe throwing darts at a wall can produce results similar to spending time and money on research, then passive investing may make more sense. ETFs provide an easy way to invest passively. Today, there are thousands of ETFs that track many different indexes. Regardless of how large the ETF market is, you only need to be aware of three specific ETFs:
The names of these ETFs are a play on the names of the indexes they follow. Whether it’s a list of 500 of the most actively traded stocks (S&P 500) or a list of 30 of the most dominant publicly traded companies (Dow Jones Industrial Average), passively managed ETFs simplify a passive investment strategy. Many other indexes track everything from stocks to bonds to currencies to commodities and more.
The first ETF - the “Spyder” - was listed for trading in 1993. For the next 15 years, only passively managed ETFs were available to investors. In 2008, the now-defunct investment bank Bear Stearns introduced the first actively managed ETF: the Bear Stearns Current Yield Fund. Although the bank would essentially go out of business later that year, it helped start a new trend in the ETF market.
Actively managed ETFs, or active ETFs, allow the fund manager to deviate from the benchmark index. For example, a large-cap active ETF would likely use the S&P 500 as its benchmark, and the manager would primarily invest in S&P 500 stocks. However, the manager isn’t required to match the index’s exact structure. If the manager was bullish on 150 of the 500* stocks in the index, they could avoid investing in the other 350.
*Technically there are more than 500 stocks in the S&P 500. As of late 2022, there were 503 stocks in the index. Regardless, this is not important for test purposes.
As discussed above, active management has pros and cons. An active ETF could outperform its benchmark if the chosen investments perform well. But the research and ongoing management provided by the fund manager and their team comes at a cost. As a result, active ETFs tend to have higher expense ratios than traditional passive ETFs.
Active ETFs are growing in popularity, but passive ETFs that closely track their benchmark index still make up most of the ETF market. According to Morningstar, active ETFs comprise 4% of the ETF market but represent 10% of all ETF inflows (as of December 31, 2021). For test purposes, assume passive ETFs are the focus of general ETF questions. Only apply active ETF characteristics if the question or answer choices explicitly bring them up.
ETFs and index mutual funds have a few important similarities. Both are structured as open-end management companies, and both can provide the “passive” returns of indexes. However, you’ll need to know key differences, including how they’re bought and sold, efficiency, and taxes.
ETFs are negotiable securities that trade in the market. When investors buy ETFs, they buy shares from other investors at the market price (plus a commission). When selling an ETF, investors sell shares to other investors at the market price (minus a commission). Negotiable securities involve trading with other investors in the secondary market.
Mutual funds are redeemable securities, and their transactions always involve the issuer. When a customer buys shares of a mutual fund, they send money to the fund sponsor, sometimes minus a sales charge. To sell a mutual fund, they send a redemption request to the mutual fund, and the issuer cashes out the shares.
Mutual funds are typically more expensive to run and manage than ETFs. There are several reasons for this, and you don’t need to know the operational details. In general, mutual funds require more behind-the-scenes work that ETFs avoid (for example, costs related to redeeming securities). One comparison that matters for the exam is active vs. passive management. Mutual funds can be actively or passively managed. However, most ETFs are passively managed (as discussed above), which generally makes them less costly to manage. Therefore, you can assume ETFs generally have lower expense ratios and are more efficient* than mutual funds.
*The lower the fees/charges, the more efficient an investment is.
Continuing with this theme, ETFs often track indexes, while many mutual funds are more actively managed. Active management typically involves more frequent buying and selling of securities. Because of this, mutual funds tend to distribute more taxable capital gains to investors. As a result, ETFs are generally more tax efficient than mutual funds.
Investors betting on market downturns or trying to amplify gains may use inverse and/or leveraged ETFs. These investments involve considerable risk, which makes them suitable only for sophisticated investors.
Inverse ETFs provide the inverse (opposite) return of the index they track. If an investor expects a market or sector to fall, an inverse ETF can be used to seek a positive return. Here’s how that works:
An investor owns an S&P 500 inverse ETF. The S&P 500 goes up 3%. What is the investor’s return?
Inverse ETF: down 3%
An investor owns an S&P 500 inverse ETF. The S&P 500 goes down 2%. What is the investor’s return?
Inverse ETF: up 2%
Leveraged ETFs provide amplified gains and losses. 200% and 300% leveraged funds are the most common. A 200% leveraged ETF targets gains and losses that are 2× the index’s move, while a 300% leveraged ETF targets 3×. Here are examples:
The S&P 500 goes up 3%. How would a 200% and 300% leveraged fund perform?
200% leveraged ETF: up 6%
300% leveraged ETF: up 9%
The S&P 500 goes down 2%. How would a 200% and 300% leveraged fund perform?
200% leveraged ETF: down 4%
300% leveraged ETF: down 6%
Leveraged inverse ETFs also exist. These combine inverse returns with leverage, which increases risk even further:
The S&P 500 goes up 3%. How would a 200% and 300% leveraged inverse fund perform?
200% leveraged inverse ETF: down 6%
300% leveraged inverse ETF: down 9%
The S&P 500 goes down 2%. How would a 200% and 300% leveraged inverse fund perform?
200% leveraged ETF: up 4%
300% leveraged ETF: up 6%
With these ETFs, returns can be excellent or disastrous. Even sophisticated investors typically use inverse or leveraged ETFs only for short periods of time. In addition to the risk, these funds often have substantial fees. You don’t need to know the mechanics, but it’s expensive for funds to obtain inverse and leveraged returns.
Bottom line: inverse, leveraged, and leveraged inverse ETFs can produce quick gains or quick losses based on market fluctuations.
Exchange traded notes (ETNs) are technically debt securities, but the Series 65 exam may discuss their similarities and differences with ETFs. Both ETNs and ETFs provide returns based on the performance of an underlying index, but they do it in different ways.
When an investor buys shares of an ETF, they gain ownership of securities held in the fund. When those securities increase in value, the ETF increases in value. The ETF’s holdings are structured to match the index it tracks. For example, the Spyder (S&P 500) ETF contains the 500 stocks part of the S&P 500. Simply put, ETF owners make money when their investments rise in value and pay income.
When an investor buys an ETN, they are loaning money to a financial institution. Officially structured as a bond, an ETN represents the issuer’s promise to pay investors the return of an index. Unlike ETFs, ETNs have a maturity date, which is the date the issuer must make its payment representing the return of the index to ETN holders.
How do ETN issuers provide the return of an index? You don’t need to know the details, mainly because the process is complicated and varies by firm. The key point is that ETNs obligate the issuer to make a payment equal to the return of an index.
Because ETNs are debt instruments, they are subject to default risk (also known as credit risk). If an ETN issuer goes bankrupt, investors could lose their entire investment. For a real-world example, see this story about Lehman Brothers ETNs. ETFs, on the other hand, don’t have default risk because they represent ownership of the underlying securities.
ETNs and ETFs are both negotiable securities that trade in the secondary market, can be bought on margin, and can be sold short. Additionally, both are tax efficient, with ETNs being more tax efficient than ETFs. Because ETNs don’t involve ownership of portfolio assets, there are no dividend or capital gains payments. Therefore, ETNs are only taxable when sold or when they mature.
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