What are Exchange traded funds?

An exchange traded fund is similar to stocks because it is traded on a stock exchange. It is a type of investment fund that holds assets such as stocks, bonds and commodities, and it trades close to its net asset value over the course of the day. An exchange traded form bears some similarities with the depository receipts. Before going further, let us analyze what a depository receipt is.

A depository receipt is a negotiable financial instrument that represents ownership of publicly traded securities. Depository receipts are issued by banks (which serves as the custodian bank; i.e it holds the actual shares) when investors purchase the stocks of foreign companies through them; they are denominated in the local currency, and this eliminates the hassles that comes with directly holding a foreign stock.

Depository receipts can be sponsored or unsponsored depository receipts. A sponsored depository receipt applies when the company issuing shares enters into an agreement with a custodian bank to make its shares available to investors in other countries, while in an unsponsored depository receipt the country makes no such agreement with a custodian bank. The major advantage of a depository receipt is that it enables a company to access investors in capital markets outside of its home country. Also, investors are not limited to geographical locations when investing in capital markets. They can invest and earn valuable returns from highly profitable companies outside the capital market of their home country. Two popular types of depository receipts are the American Depository receipt and the Global depository receipt.

Exchange Traded Funds

Now that we have examined depository receipts, how is an exchange traded fund similar?

Like the depository receipt, an exchange traded fund is also a negotiable financial instrument.  At the inception of the exchange traded fund, precisely in the 90’s, executives at the American stock exchange created an investment company that issued depository receipts against the S & P 500 index. The company bought chunks of shares from companies listed in the S&P 500 index and issued depository receipts to investors who were willing to purchase it.  It was called the Standard and poor’s depository receipt, now simply known as the spider. ETF’s are registered with the SEC under the same law that governs the operation of open ended mutual funds, but the SEC granted an exemption enabling them to issue depository receipts. There was a condition though, and it was that they only issue depository receipts based on combined investments in only passively managed indexes. This was lifted in the late 2000’s, and ETF’s were allowed to issue depository receipts on investments in actively managed securities.

Actively managed ETF’s have an advantage over mutual funds. This is because like a mutual fund, the management of an actively managed ETF is vested in the hands of experts who manage the fund and seek out investments with the potential of earning greater than average returns; but it comes also with an increased ease of trading your ETF on the exchange at any time you desire. Although it is an advantage to be able to easily trade your ETF, it may also serve as a big disadvantage. This is because like the stock market, the price of an ETF might be changing at the exact time of executing a trade; this may result into a gain or loss on a trade. You need to exercise extra caution and due diligence in knowing what is actually in the fund when you want to trade.

Exchange traded fund’s flexible trading brings with it an advantage over mutual fund in the area of taxes. Although taxes are incurred in both investment funds, an ETF enables you to choose either a short term capital gains tax or long term capital gains tax since you make the decision on when to sell it. Mutual funds on the other hand do not pay tax, this is because they pass all dividend income and capital gains on to investors; by so doing, they also pass on taxes to investors in the form of income tax on dividends and capital gains tax on capital gains.  The mutual fund manager reports dividend and capital gains yearly to the appropriate government authority. Taxes are calculated on both dividend and capital gains, and investors are required to pay such taxes.

Another advantage of exchange traded fund is the lower cost of operation as compared with an open ended mutual fund. A mutual fund deals directly with investors, they maintain individual accounts which makes it an indurate process, and increases the cost of running such a fund. An exchange traded fund on the other hand is held by investors in their brokerage account. Individual accounts are not needed for individual investors, and this reduces the cost of running such a fund.

An exchange traded fund also edges a mutual fund in the aspect of returns. It is as a result of the cash set aside for investors who wish to redeem their investment in a mutual fund. The cash is generally not invested because it may be needed on demand to settle investors. This therefore lowers the expected return of the mutual fund. An exchange traded fund on the other hand doesn’t have to set aside any extra cash for redemption because redeeming an ETF simply means selling your holdings to another investor at the current market price. This implies that an ETF would have more money available for investing with, and this raises the expected return of the ETF for investors.

A drawback of the ETF is trading costs. Trading ETF’s is not free, some costs are incurred, and if trading is too frequent, the costs might prove to be quite substantial. Another drawback is in the pricing of the ETF. The price of an ETF share should represent the market value of the underlying pool of assets the ETF invests in. This may not always be the case as an ETF may occasionally become over valued or undervalued. Investors run the risk of over paying for a share in an ETF or losing money by selling at a price below the value of the ETF. Thanks to arbitrage, ETF’s and the index it invests in agree at a mutual price.

Arbitrage is the simultaneous buying and selling of a financial instrument in different markets or in a derivative form in other to take advantage of differing prices of the same asset. In an ETF for example, if the ETF is overvalued with the price rising significantly higher than the index it represents, investors would rush to buy the shares in the index making up the ETF, then sell it to the bank that issues the depository receipts in exchange for depository receipts. After that, the investor trades the depository receipt and sells it for a higher price, thereby profiting from the sale. The law of demand and supply comes into play later on. The increase in demand for the shares would drive up the price of the index, while the increase in supply of the ETF shares would make the price decline. This happens until the prices of both the index and the ETF agree.

Recommended Reading

Joanne M Hill., Dave Nadig., Matt Hougan., Deborah Fuhr., A Comprehensive Guide to Exchange Traded Funds (ETFs)

Richard Ferry., The ETF Book: All You Need to Know About Exchange-Traded Funds