An exchange-traded fund (ETF) is technically structured as an open-end management company, but it isn’t a mutual fund. That can sound contradictory at first, so here’s the key distinction: ETFs are organized like open-end funds, but they trade like stocks. 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 represent 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, buying one (or a few) shares can provide instant diversification.
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 manipulate the market price back to 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 generally profit when the S&P 500 rises and lose money when it falls. This approach is called passive investing: instead of selecting individual stocks, bonds, and other securities, you invest in an index that represents a broad segment of the market. Since indexes track large segments of the market, a passively managed ETF is essentially a bet on the “market average,” rather than an attempt to pick the best individual investments.
Research and data are often cited in support of this approach. For example, the Wall Street Journal ran an experiment for many years that involved blindfolding their writers and having them throw darts at lists of stocks. A portfolio was constructed using the stocks 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 involves selecting specific investments rather than “taking the average.” Active investors (like the professionals in the dart-throwing article) usually measure performance against a relevant index. For example, an active investor focused on large-cap stocks (stocks of larger companies) would likely compare results to the S&P 500. If the portfolio outperforms the S&P 500, the investor “beats the market.” The goal of active strategies is to consistently beat the benchmark 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 that broad market exposure can produce results comparable to (or better than) costly research and frequent trading, passive investing may be the preferred approach. ETFs make passive investing easy. Today, thousands of ETFs 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 plays on the names of the indexes they follow. Whether it’s a list of 500 widely held stocks (S&P 500) or a list of 30 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, ETFs available to investors were only passively managed. In 2008, the now-defunct investment bank Bear Stearns introduced the first actively managed ETF: the Bear Stearns Current Yield Fund. Although the bank essentially went 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 is 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 index if the manager’s selections perform well. However, the research and ongoing management provided by the 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.
There are a few important similarities between ETFs and index mutual funds. Both are structured as open-end management companies and 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 always 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 submit 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, but most ETFs are passively managed (as discussed above). Passive portfolios are generally less costly to manage. As a result, 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 generally track indexes, while many mutual funds are more actively managed. Active management typically involves buying and selling securities more frequently. 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 who want to bet on market downturns or 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 believes a market or sector will 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 a few 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 the inverse return 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 over short periods. Even sophisticated investors typically use inverse or leveraged ETFs only for short holding periods. In addition to the risk, these products 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 66 exam may compare them to 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. If those securities increase in value, the ETF’s value increases. The ETF’s holdings are structured to match the index it tracks. For example, the Spyder (S&P 500) ETF holds the stocks that make up the S&P 500. In simple terms, ETF owners make money when the underlying holdings rise in value and when the fund pays income.
When an investor buys an ETN, they are lending money to a financial institution. Although it’s structured like a bond, an ETN is essentially 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 index’s return to ETN holders.
How ETN issuers generate the index return can be complex and varies by firm, so you don’t need to know the details. 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 held by the fund.
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 generally 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 typically only taxable when sold or when they mature.
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