An exchange-traded fund (ETF) is technically structured as an open-end management company, but it’s not a mutual fund. That may sound confusing, but ETFs are unique. While they are structured and operate as an open-end management company, they are not bought and sold the same way mutual funds are. As their name suggests, ETFs trade on exchanges in the secondary market and are negotiable securities (trade between investors).
ETFs share many similar characteristics with open-end and closed-end funds. They purchase and hold securities in a large portfolio on behalf of their investors. ETFs have net asset values (NAVs) that provide the value of the assets in the fund, which is calculated once per day based on the closing value of the securities in the portfolio. Due to the large number of securities in most ETF portfolios, instant diversification is obtained when purchasing 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 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.
Passively managed ETFs
ETFs are known for tracking indexes. For example, the most popular ETF 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, which avoids investing in specific stocks, bonds, and other securities. Remember, indexes track large segments of the market. By investing in a passively managed ETF, investors bet on the “market average” instead of trying to pick the best investments.
Research and data exist to support this approach to investing. 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 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 edged out both 44% of the time. Given professional (active) management involves added costs and fees, the results certainly make a case 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 exact opposite approach, which involves picking the best investments available (instead of “taking the average”). Active investors (like the professionals mentioned above in the dart-throwing article) usually measure their performance against an applicable index. For example, an active investor in large-cap stocks (stocks of larger companies) would likely compare their performance to the S&P 500. If their investments outperformed the S&P 500, they “beat the market.” Active investment strategies seek to consistently beat their comparable index, which is very tough to do every 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 produces similar results as spending time and money on research, then you should passively invest. ETFs provide an easy way to do this. Today, there are thousands of ETFs available that track all different types of indexes. Regardless of the size of the ETF market, 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 the pursuit of a passive investment strategy. There are many other indexes that track everything from stocks, to bonds, to currencies, to commodities, and more.
Actively managed ETFs
The first ETF - the “Spyder” - was listed for trading in 1993. For the next 15 years, only passively managed ETFs were made 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, they started a new trend in the ETF markets.
Actively managed ETFs, or simply active ETFs, grant the fund manager the ability to deviate from their benchmark index. For example, a large-cap active ETF would likely consider the S&P 500 its benchmark index, and the fund manager would primarily invest in S&P 500 stocks. However, they are under no obligation to match the exact structure of the index. If they were bullish on 150 of the 500* stocks in the index, they could simply avoid investing in the other 350 stocks.
*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 we discussed above, active management comes with pros and cons. An active ETF could outperform its benchmark index if the chosen investments perform well. But, the added service of research and asset management the fund manager and their team provide comes at a cost. Therefore, active ETFs maintain higher expense ratios than traditional passive ETFs.
Active ETFs are gaining in popularity, but passive ETFs that closely track their benchmark index still comprise a majority of the ETF market. According to Morningstar, active ETFs only comprise 4% of the ETF market, but represent 10% of all ETF inflows (as of December 31, 2021). For test purposes, you should assume passive ETFs are the focus of general ETF test questions on the exam. Only consider active ETF characteristics if explicitly brought up in the question or answers.
ETFs vs. index mutual funds
There are a few prominent similarities between ETFs and index mutual funds. Both are structured as open-end management companies and allow investors to obtain the “passive” returns of indexes. Regardless, there are differences between the two that you’ll need to be aware of, including the way they’re bought and sold, efficiency, and taxes.
ETFs are negotiable securities that trade in the market. When investors purchase ETFs, they purchase 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 securities 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 their money to the fund sponsor, sometimes minus a sales charge. To sell a mutual fund, they send a distribution 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 a number of reasons for this, which you don’t need to be keenly aware of. In general, mutual funds require a fair amount of behind-the-scenes work that ETFs avoid (e.g. costs related to redeeming securities). However, there is one important comparison to be mindful of - active or passive management. There are a number of active and passively managed mutual funds available to investors. However, the vast majority of ETFs are passively managed (as we discussed above), which means these portfolios are less costly to manage. Therefore, it can be assumed ETFs generally incur 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 lists of securities (indexes), while many mutual funds are more actively managed. Whenever active management is involved, more securities are bought and sold on a regular basis. Because of this, mutual funds tend to distribute more taxable capital gains to their investors. As a result, ETFs are generally more tax efficient than mutual funds.
Leveraged & inverse ETFs
Investors betting on market downturns or seeking to amplify their gains could purchase inverse and/or leveraged ETFs. These investments come with considerable risk, which makes them suitable only for sophisticated investors.
Inverse ETFs provide the inverse (opposite) return of the index they track. For investors betting that a market or sector is going to fall generally, inverse ETFs can be utilized to make a return. Here’s how these would work:
An investor owns an S&P 500 inverse ETF. The S&P 500 goes up 3%. What is the investor’s return?
(spoiler)
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?
(spoiler)
Inverse ETF: up 2%
Leveraged ETFs provide amplified gains and losses to their investors. 200% and 300% leveraged funds are the most common leveraged ETFs. 200% leveraged ETFs amplify gains and losses by a factor of 2, while 300% leveraged ETFs amplify gains and losses by a factor of 3. Let’s take a look at a few examples of how these work:
The S&P 500 goes up 3%. How would a 200% and 300% leveraged fund perform?
(spoiler)
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?
(spoiler)
200% leveraged ETF: down 4%
300% leveraged ETF: down 6%
Leveraged inverse ETFs also exist in the market. In essence, they’re leveraged and inverse ETFs molded together as one. Leveraged inverse ETFs come with considerable risk, as you’ll see below:
The S&P 500 goes up 3%. How would a 200% and 300% leveraged inverse fund perform?
(spoiler)
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?
(spoiler)
200% leveraged ETF: up 4%
300% leveraged ETF: up 6%
With these ETFs, returns can be amazing or terrible. Even the most sophisticated investors should only maintain an investment in inverse or leveraged ETFs for short periods of time. Not only are they risky, but they come with substantial fees. Although you don’t need to know the specifics, it’s expensive for funds to obtain inverse and leveraged returns.
Bottom line - inverse, leveraged, and leveraged inverse ETFs provide ways to make or lose quick money based on market fluctuations.
Exchange traded notes (ETNs)
Exchange traded notes (ETNs) are technically debt securities, but the Series 66 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 purchases shares of an ETF, they gain ownership of securities in the fund. When those securities in the fund increase in value, the ETF increases in value. The securities in the ETF are structured in a way to perfectly 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 purchases an ETN, they are loaning money to a financial institution. Officially structured as a bond, an ETN represents the promise from an issuer to pay its investors the return of an index. Unlike ETFs, ETNs have a maturity date, which is the day the issuer must make its payment representing the return of the index to their ETN holders.
How exactly do ETN issuers provide the return of an index? You don’t need to worry about how, mainly because it’s fairly complicated and varies from firm to firm. Ultimately, ETNs obligate their issuer to make a payment equal to the return of an index to its investors.
Because ETNs are considered debt instruments, they are subject to default risk (also known as credit risk). If an ETN issuer goes bankrupt, its investors could lose their entire investment. For a real-world example, check this story about Lehman Brothers ETNs. ETFs, on the other hand, don’t have default risk as they represent ownership of the underlying securities in the ETF.
ETNs and ETFs are both negotiable securities that actively trade in the secondary market, can be bought on margin, and sold short. Additionally, both are tax efficient, with ETNs being more tax efficient than ETFs. Because there is no ownership of portfolio assets involved with an ETN, there are no dividend or capital gains payments. Therefore, ETNs are only taxable when sold or when they mature.
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