ETF Mechanics
Let's dive into the detail a little more on exactly how ETFs work. This article does not apply to exchange traded notes, which function differently.
Trading mechanics
Unlike mutual fund shares, ETF shares are traded on an exchange, so investors purchase and sell ETF shares in market transactions. ETF shares are purchased from, and sold to, other investors. This is in contrast to a mutual fund, where an investor buys a share directly from the mutual fund, and then "sells" or "redeems" those shares from the mutual fund itself.
When an ETF initially goes public, or when an ETF wants to issue additional shares, it does so by selling shares to one or more financial institutions known as “Authorized Participants.” Authorized participants typically are large broker-dealers. Only authorized participants are permitted to purchase and redeem shares directly from the ETF, and they can do so only in large aggregations or blocks commonly called “creation units” or a "creation basket". Each ETF can specify how big the creation basket is, but 50,000 shares is typical.
To purchase shares from an ETF, an authorized participant assembles and deposits a designated basket of securities and cash with the fund in exchange for which it receives shares in the ETF. Once the authorized participant receives the ETF shares, the authorized participant is free to sell the ETF shares in the secondary market to individual investors, institutions, or market makers in the ETF.
The redemption process is the reverse of the creation process. An authorized participant buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the authorized participant receives a pre-defined basket of individual securities, or the cash equivalent. Most ETFs charge the authorized participants a fee for each of these "creation basket" transactions, but it is usually not very large. A fee of $350 per transaction is typical.
The fact that an ETF does not interact with the public directly is one small advantage the ETF structure has over a mutual fund. The cost of running an ETF is smaller, because an ETF does not have to maintain as large of an administrative and customer service staff to deal with the public. Further, an ETF can be more fully invested at all times, compared to a mutual fund that has to keep some cash on hand in order to deal with redemption requests from the public.
Net asset value
An ETF, like other investment funds, including mutual funds and closed-end funds, must calculate its "NAV" --the value of all its assets minus all its liabilities-- every business day, which is done typically at the close of the New York Stock Exchange. Unlike other fund types, however, an ETF calculates its estimated NAV approximately every 15 seconds throughout the business day. This estimated NAV (called the IIV – for intraday indicative value – or IOPV – for intraday operative value – depending on the exchange on which the ETF lists) is unique to ETFs and is based on the estimated value of the ETF’s holdings, minus its liabilities, throughout the trading day.
With a mutual fund, when an investor buys or sell shares in the fund, all transactions are conducted at the fund's end of day NAV, less transaction fees. Since the shares of an ETF are traded throughout the day on an exchange, ETF shares are bought and sold at market prices, which may be higher or lower than the ETF's NAV.
Normally, it would be of concern to an investor if the market prices were significantly different than the NAV. However, one advantage to the ETF structure is that an ETF’s market price is generally kept close to the ETF’s NAV because of "arbitrage" by the authorized participants.
Arbitrage is a common investing term for the practice of taking advantage of a price differential between two or more markets. An arbitrage opportunity is inherent in the ETF structure. The authorized participants can make money trading the ETF shares, and in doing so, they benefit everyone by keeping the market price of the ETF close to the NAV of the ETF.
Here is how it works. At any time, the authorized participants can buy the shares of the securities included in the ETF's creation basket, and give them to the ETF in exchange for shares of the ETF priced at the ETF's NAV. The authorized participants can then sell those ETF shares on the open market. Even though the authorized participants pay a small transaction fee for this exchange, they can make money on the exchange if the ETF's shares are trading at a premium to the ETF's NAV. The expected result of the arbitrage activity is that the market value of the ETF moves back in line with the ETF’s NAV per share , as more shares of the ETF are now available to be bought and sold.
For U.S. stocks that are highly liquid, the arbitrage by the authorized participants is highly effective. The authorized participants, who are sophisticated traders, can easily execute these creation basket exchanges, even if the margins at first blush seem pretty small. The process is not quite as effective for other securities that are not as liquid, such as bonds or global equities, as it is more difficult for the authorized participants to easily and cheaply accumulate the securities in the creation basket. The arbitrage process isn't perfect, but it does generally work. You can visit the website of an ETF to compare at any time the market price of the ETF to the ETF's NAV.
By way of comparison, closed-end investment funds, which are also traded on an exchange, do not have the authorized participant and arbitrage setup of an ETF. They are called "closed-end" funds because they do not issue or redeem shares in response to market trading. So closed-end funds often trade at market prices that can be significantly different than their net asset values. You can read more in what is a closed-end fund? So from a pure structure stand point, ETFs are designed better than both mutual funds and closed-end funds.
Why are ETFs more tax efficient that mutual funds?
ETFs are typically significantly more tax efficient than a mutual fund because they make fewer dividend distributions related to capital gains. Here's why.
In order to avoid tax at a fund level, investment funds like mutual funds and ETFs are required by federal law to distribute to their shareholders any capital gains, so that the shareholders can pay taxes on those capital gains. Even though investment funds pay out to investors "dividends" related to these capital gains, which at first blush seems like a good thing, in the long run capital gains distributions are a bad thing for investors. It is better for the investor to keep all the money invested in the fund, earning compounded returns.
There are several reasons why ETFs generate fewer capital gains than mutual funds. First, most ETFs are index funds that have lower turnover compared to an actively managed mutual fund, so there are fewer times when an ETF will generate a capital gain selling securities.
Second, as explained above, when an investor in an ETF sells shares, the investor is selling shares to other investors, so the ETF is not required to sell any securities in order to redeem shares. A mutual fund, on the other hand, often has to sell securities in order to redeem shares directly from mutual fund investors, resulting in more capital gains.
Third, the process of an ETF creating or redeeming shares through an authorized participant can often be done in a "tax free" way. If possible, the ETF and the authorized participant will create or redeem shares in the ETF merely by transferring to each other shares in the underlying securities the ETF is investing in. These transfers are typically cashless transactions that are not taxed. This also helps minimize the number of capital gains generated by an ETF.
Fund legal and tax structures
There are three kinds of fund structures for exchange traded products:
- ETFs registered with the SEC under the Investment Company Act of 1940 (the “1940 Act”) as either an open-end investment company (generally known as “funds”) or a unit investment trust
- ETFs that are exchange traded commodity pools
- Exchange traded notes, or ETNs
An exchange traded note, or ETN, is substantially different than an exchange traded fund, or ETF, as an ETN is an unsecured liability of the bank that issued it, as explained in what is an ETN?
For ETFs, the type of legal structure has a significant impact on the tax treatment of your investment in the ETF. So let's run through the different scenarios.
Most investment companies registered with the SEC under the Investment Company Act of 1940 elect to be treated as regulated investment companies under the Internal Revenue Code in order to avoid paying entity level income taxes.
There are a few ETFs that buy and sell master limited partnerships ("MLPs") that are setup as C corporations, and so they do pay tax at a fund level. These MLP ETFs that are C corporations require some extra analysis to understand the impact of the C corporation status.
Exchange traded commodity pools come in two forms:
- Grantor trusts
- Limited partnerships
Grantor trusts are used for "physically held" precious metals ETFs. Under current IRS rules, investments in these precious metals ETFs are considered collectibles. Collectibles never qualify for the 20 percent long-term tax rate applied to traditional equity investments; instead, long-term gains are taxed at a maximum rate of 28 percent. If shares are held for one year or less, gains are taxed as ordinary income; again, at a maximum rate of 39.6 percent.
Limited partnerships are used by commodity ETFs that buy and sell commodity futures. Futures-based funds have unique tax implications. Currently, 60 percent of any gains are taxed at the long-term capital gains rate of 20 percent, and the remaining 40 percent is taxed at the investor's ordinary income rate, regardless of how long the shares are held. This comes out to a blended maximum capital gains rate of 27.84 percent.
Limited partnership ETFs are considered pass-through investments, so any gains made by the trust are "marked to market" at the end of each year and passed on to its investors, potentially creating a taxable event. This means your cost basis adjusts at year-end, and you can be subject to paying taxes on gains whether or not you sold your shares. For tax reporting, limited partnership ETFs also generate a Schedule K-1 form. This can create uncertainty and annoyance for the average investor not familiar with K-1s when they receive these forms in the mail.
To avoid the need to send a K-1 to investors, some ETF sponsors have recently launched "K-1 Free" ETFs. They are able to avoid a K-1 by creating a subsidiary in a foreign country, like the Cayman Islands, that does all the buying and selling of commodity futures. The foreign subsidiary can then remit all of its earnings to the U.S. parent company ETF in a way to avoid the K-1 treatment.
Fundamental versus non-fundamental investment policies
An ETF generally adopts two kinds of investment policies: a fundamental set of policies and a non-fundamental set of policies. The fundamental policies are generally those policies that can only be changed by a vote of the fund's shareholders. The non-fundamental policies are those policies that can be changed by the fund's Board of Directors, without a shareholder vote, as long as they give suitable notice to the shareholders.
To ensure the flexibility to respond to market conditions, most ETFs have adopted fundamental policies that are pretty broad, as they don't really want to have to hold a shareholder vote very often. So most of the investment policies that investors focus on are non-fundamental investment policies that can be changed by the Board, without a shareholder vote. For example, the policy that a fund will seek to track an index is usually a non-fundamental policy.
Because it is usually easy to do so (i.e. because the policy is non-fundamental), ETFs change their investment policies all the time.
How they track an index
Most ETFs today seek to track the performance of an index, before fees and expenses. How do they do it?
When an ETF is formed, the sponsor has to adopt an investment policy as to how the ETF will seek to track the index it is following. There are two methods:
- Full replication
- Index sampling
A policy of full replication means that the ETF will always own all of the securities in the index it is following. A policy of index sampling means that the ETF will judgmentally own only a subset of the securities owned by the index it is following.
For the U.S. stock market, which is highly liquid, the full replication method works great. But some times, it is not practical to buy and own all of the securities in an index.
An ETF that invests in emerging market stocks has to buy thousands of stocks from 20+ stock markets around the world. Although the world's stock markets are getting more tightly connected with the use of technology, at times it is not an easy task.
Bond indexes are also very difficult to replicate, because of the nature of the U.S. bond market. There are thousands of publicly issued bonds, many of which are almost never traded (because the original buyer holds onto the bond until maturity). So it is very difficult to track a bond index using full replication.
Under index sampling, an ETF judgmentally decides how many of the securities in the index to buy, and which ones. The idea is to use a sophisticated enough "sampling" methodology so that the securities that the ETF does own will accurately track the index. If the ETF does a poor job of sampling, the ETF's investment results will not accurately track that of the index.
Virtually all bond ETFs use index sampling due the illiquid nature of bond indexes.
What else are they buying?
Occasionally, you will notice that an ETF is holding a security that you don't expect it to be holding, as the security is not in the index that the ETF is tracking. This occurs because the ETF has adopted an investment policy that only requires the ETF to invest most, but not all, of their assets in securities in the index. Typically, the ETF's investment policy states that 80% of the ETF's assets must be invested in securities in the index. The other 20% of an ETF's assets can be invested in other securities, as the discretion of the ETF's management.
The great thing about ETFs is that you can go to their websites and find detailed information on what investments the ETF is making. Most ETFs that track an index disclose on their website an updated list of their investment holdings, on a daily basis.
If you go to the ETF's website, you can usually find the "summary prospectus" for the ETF, which will explain in detail what the ETF's investment policy really is. We don't have exact figures, but most ETFs include a policy stating that they will invest 80% of their assets in securities in the index. But some ETFs use a 90% or even a 95% figure.
This "other" window is tricky. The ETF can't deviate too much from the securities in the index, as the ETF will risk losing track of the performance of the index. Most ETF managers genuinely want to do everything they can to precisely track the index. So they tend to not deviate too much from the securities in the index.