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2020 Curriculum CFA Program Level II Portfolio Management and Wealth Planning

Exchange Traded Funds: Mechanics and Applications

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Introduction

Exchange-traded funds (ETFs) have grown rapidly since their invention in the early 1990s, in large part because of their low associated cost, exchange access, holdings transparency, and range of asset classes available. Growth in ETFs has also been driven by the increased use of index-based investing. ETF investors need to understand how these products work and trade and how to choose from the numerous options available. Although many ETFs are organized under the same regulation as mutual fund products, there are important differences related to trading and tax efficiency. ETFs have features that can make them more tax efficient than traditional mutual funds, and not all ETFs are organized like mutual funds. ETFs can be based on derivative strategies, use leverage and shorting, and be offered in alternate structures, such as exchange-traded notes (ETNs), which have their own unique risks.

Understanding how ETF shares are created and redeemed is key to understanding how these products can add value in a portfolio. Since so many ETFs track indexes, understanding their index tracking or tracking error is also critical. Investors should also understand how to assess an ETF’s trading costs, including differences between the ETF’s market price and the fair value of its portfolio holdings.

This reading is organized as follows: Section 2 discusses ETF primary and secondary markets, including the creation/redemption process. Section 3 covers important investor considerations, such as costs and risks, when choosing an ETF. Section 4 explains how ETFs are used in strategic, tactical, and portfolio efficiency applications. Section 5 concludes and summarizes the reading. 

Learning Outcomes

The member should be able to:

  • explain the creation/redemption process of ETFs and the function of authorized participants;
  • describe how ETFs are traded in secondary markets;

  • describe sources of tracking error for ETFs;

  • describe factors affecting ETF bid–ask spreads;

  • describe sources of ETF premiums and discounts to NAV;

  • describe costs of owning an ETF;

  • describe types of ETF risk;

  • identify and describe portfolio uses of ETFs.

Summary

In this reading, we have examined important considerations for ETF investors, including how ETFs work and trade, tax efficient attributes, and key portfolio uses. The following is a summary of key points:

  • ETFs rely on a creation/redemption mechanism that allows for the continuous creation and redemption of ETF shares.

  • The only investors who can create or redeem new ETF shares are a special group of institutional investors called authorized participants.

  • ETFs trade on both the primary market (directly between APs and issuers) and on the secondary markets (exchange-based or over-the-counter trades like listed equity).

  • End investors trade ETFs on the secondary markets, like stocks.

  • Holding period performance deviations (tracking differences) are more useful than the standard deviation of daily return differences (tracking error).

  • ETF tracking differences from the index occur for the following reasons:

    • fees and expenses,

    • representative sampling/optimization,

    • use of depositary receipts and other ETFs,

    • index changes,

    • fund accounting practices,

    • regulatory and tax requirements, and

    • asset manager operations.

  • ETFs are generally taxed like the securities they hold, with some nuances:

    • ETFs are more tax fair than traditional mutual funds, because portfolio trading is generally not required when money enters or exits an ETF.

    • Owing to the creation/redemption process, ETFs can be more tax efficient than mutual funds.

    • ETF issuers can redeem out low-cost-basis securities to minimize future taxable gains.

    • Local markets have unique ETF taxation issues that should be considered.

  • ETF bid–ask spreads vary by trade size and are usually published for smaller trade sizes. They are tightest for ETFs that are very liquid and have continuous two-way order flow. For less liquid ETFs, the following factors can determine the quoted bid–ask spread of an ETF trade:

    • Creation/redemption costs, brokerage and exchange fees

    • Bid–ask spread of underlying securities held by the ETF

    • Risk of hedging or carry positions by liquidity provider

    • Market makers’ target profit spread

  • ETF bid–ask spreads on fixed income relative to equity tend to be wider because the underlying bonds trade in dealer markets and hedging is more difficult. Spreads on ETFs holding international stocks are tightest when the underlying security markets are open for trading.

  • ETF premiums and discounts refer to the difference between the exchange price of the ETF and the fund’s calculated NAV, based on the prices of the underlying securities and weighted by the portfolio positions at the start of each trading day. Premiums and discounts can occur because NAVs are based on the last traded prices, which may be observed at a time lag to the ETF price, or because the ETF is more liquid and more reflective of current information and supply and demand than the underlying securities in rapidly changing markets.

  • Costs of ETF ownership may be positive or negative and include both explicit and implicit costs. The main components of ETF cost are

    • the fund management fee;

    • tracking error;

    • portfolio turnover;

    • trading costs, such as commissions, bid–ask spreads, and premiums/discounts;

    • taxable gains/losses; and

    • security lending.

  • Trading costs are incurred when the position is entered and exited. These one-time costs decrease as a portion of total holding costs over longer holding periods and are a more significant consideration for shorter-term tactical ETF traders.

  • Other costs, such as management fees and portfolio turnover, increase as a proportion of overall cost as the investor holding period lengthens. These costs are a more significant consideration for longer-term buy-and-hold investors.

  • ETFs are different from exchange-traded notes, although both use the creation/redemption process.

    • Exchange-traded notes carry unique counterparty risks of default.

    • Swap-based ETFs may carry counterparty risk.

    • ETFs, like mutual funds, may lend their securities, creating risk of counterparty default.

    • ETF closures can create unexpected tax liabilities.

  • ETFs are used for core asset class exposure, multi-asset, dynamic, and tactical strategies based on investment views or changing market conditions; for factor or smart beta strategies with a goal to improve return or modify portfolio risk; and for portfolio efficiency applications, such as rebalancing, liquidity management, completion strategies, and transitions.

  • ETFs are useful for investing cash inflows, as well as for raising proceeds to provide for client withdrawals. ETFs are used for rebalancing to target asset class weights and for “completion strategies” to fill a temporary gap in an asset class category, sector, or investment theme or when external managers are underweight. When positions are in transition from one external manager to another, ETFs are often used as the temporary holding and may be used to fund the new manager.

  • All types of investors use ETFs to establish low-cost core exposure to asset classes, equity style benchmarks, fixed-income categories, and commodities.

  • For more tactical investing, thematic ETFs are used in active portfolio management and represent narrow or niche areas of the equity market not well represented by industry or sector ETFs.

  • Systematic, active strategies that use rules-based benchmarks for exposure to such factors as size, value, momentum, quality, or dividend tilts or combinations of these factors are frequently implemented with ETFs.

  • Multi-asset and global asset allocation or macro strategies that manage positions dynamically as market conditions change are also areas where ETFs are frequently used.

  • Proper utilization requires investors to carefully research and assess the ETF’s index construction methodology, costs, risks, and performance history. 

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