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Like a traditional mutual fund, an index ETF is a investment structure that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. Unlike a mutual fund, an index ETF is created when an institutional investor deposits securities into the fund in return for creation units. In return for the deposit, the institutional investor receives a fixed amount of shares, some or all of which may be traded and priced throughout the day on a stock exchange such as the American Stock Exchange (AMEX). Retail investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund - rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of index ETFs.
Actually, HOLDRs and other basket-based products are not truly index ETFs. This is a term that has evolved over the years and has been adopted by investors, but is not wholly accurate. A unit investment trust is not a fund. HOLDRs are grantor trusts, which are non-registered securities, not funds.
Unit investment trusts are created for a specific, limited purpose, and do not have a board of directors or an investment advisor. Therefore, these trusts do not make discretionary investment decisions. Funds operated by managed investment companies, however, do make discretionary investment decisions, at least within the confines of the fund investment guidelines.
There is no consensus on this point of view, although the odds are against index ETFs replacing traditional index mutual funds. Due to the expense of dollar-cost averaging index ETFs for an active investment strategy (brokerage commissions must still be paid for each purchase or sale), traditional index mutual funds still hold a cost advantage.
Provided that the index ETF is a registered investment company, the voting rights are held by the fund managers, not the fund shareholders. For those funds that are not registered investment companies, such as HOLDRs, the fund arranges for the delivery of proxy material to the investors, who do have voting rights associated with the underlying securities in the HOLDR trusts.
Investors buy and sell index ETFs like stocks, typically through a brokerage account. Investors can also employ traditional stock trading techniques, including stop orders, limit orders, margin purchases, and short sales. As with all stocks, you may be required to deposit more money or securities into your margin account if the equity including the amount attributable to your index ETFs shares, in your account declines.
Taxes must be paid on all dividend distributions made by the underlying securities and any capital gains associated with transactions made by the fund. However, since index ETFs offer in-kind redemptions, they can avoid realizing capital gains for the fund (although shareholders must still pay any taxes due upon most sales of the underlying securities).
Unlike other stocks, which can be held in book entry or certificate form, certificates are not available for most index ETFs. The only certificate is held by the Depository Trust Company , and the number of shares represented by that certificate is "marked to market" for increases and decreases in shares as creations and redemptions occur.
Due to reduced marketing and distribution expenses and the passive nature of index investing, the expense ratios are typically lower than those of many traditional mutual funds. For index ETFs that are not registered investment companies (i.e. HOLDRs), an annual custody fee of 0.08% is charged if any of the underlying stocks pay dividends. However, investors must still pay a brokerage commission to purchase and sell shares for all index ETFs. For those investors who trade frequently, this can significantly increase the cost of investing in index ETFs. So while index ETFs may have lower expense ratios, the total costs to the investor may not be lower.
In addition, shareholder accounting for index ETFs is maintained at the investor's brokerage firm, rather than at the fund. This creates no problems for the shareholder, although it does have some significance for the distribution of index ETFs. One of the traditional functions of the mutual fund transfer agent is to keep track of the salesperson responsible for the placement of a particular fund position, so that any ongoing payments based on 12b-1 fees or other marketing charges can be made to the credit of the appropriate salesperson. index ETF expenses tend to reflect the cost savings of this function.
The price of an index ETF typically resembles, but is independent of, the underlying net-asset-value of the fund. Unlike closed-end ETFs, the shares for an index ETF can be created or deemed on a daily basis by market specialists. If the specialist is not maintaining an orderly market in a fund, and institution can exchange shares in-kind (in 50,000 share lots) to minimize any price to net asset value gap.
Tracking error is the difference between the returns of a fund and the returns of the index that it attempts to duplicate. This tracking error arises primarily because of the forces of supply and demand that determine market prices for these funds. The other type of tracking error, although less relevant to the investors as it does not influence fund performance, is the difference between the net asset value of the index ETF and the underlying index. This difference may arise due to product fees, difference in dividend handling and differences in index composition.
Index ETFs handle dividends in different ways. iShares reinvest dividends in the fund when they are paid. Most funds, such as SPY and QQQ, hold dividends in cash-equivalent instruments until a pre-determined distribution, typically at the end of each month or quarter. HOLDRs distribute cash dividends immediately. In any case, whether the fund distributes or reinvests the dividends, this is still a taxable event for the shareholder.
Fundamentally, the perceived value of a fund's shares may be less than the reported value of the fund's underlying assets. In addition, poor performance, illiquid securities, poor name recognition, and large unrealized gains may prompt a fund to trade at a discount. Tracking error is also introduced through fees and expenses (which are not incorporated in the underlying indexes) and optimization rather than replication (due to compliance with the 40 Act).
Index ETFs do not currently use leverage. However, the SEC has approved the use of leverage for conventional index funds, so the use of leverage by index ETFs may not be far away.
For example, instead of purchasing the S&P Depository Receipts (SPY), an investor may purchase the nine Select Sector SPDRs. Although this may seem imprudent at first, the investor now has the ability to realize losses in specific sectors, whereas a broad market index does not have this ability. For example, in 1999, while the S&P 500 was up 19.1%, several constituent sectors were down. An investor that holds the underlying sector funds individually would be able to sell the poorly performing sectors to offset gains in the remainder of his portfolio. Please note that the sector used for the nine Select Sector SPDRs are determined by the Merrill Lynch Research Department, not Standard & Poor's.
Although there are currently no actively managed index ETFs in the United States, several such funds have been launched in Europe. These funds announce their holdings to market makers on a two-day lag and to the general public on a two-month lag. This information distribution process may be problematic for the SEC and the market makers in the United States, although there are ideas for appeasing these concerns.
Although an index ETF and a futures contract may represent ownership of the same underlying index, there are more index ETFs available for indexes than futures contracts, especially for style, sector and industry categories. Futures contracts depend on continuous customer order flow, while few of the style, sector and industry indexes are characterized by continuous order flow. In addition, index ETFs trade in much smaller investment sizes than futures contracts. For instance, the S&P 500 SPDR trades at five times less than the corresponding futures contract. Of course, investors may also prefer the ease of trading a stock rather than a futures contract, which requires separate accounts and daily mark-to-market of gains and losses.
Index ETFs provide investors with exposure to broad segments markets. They cover a range of style and size spectrums, together with sector-specific funds, enabling investors to build customized investment portfolios consistent with their financial needs, risk tolerance, and investment horizon. Both institutional and retail investors use index ETFs to gain exposure that would otherwise be cost-prohibitive and extremely complex to build from scratch.
Index ETFs can be an excellent hedging vehicle because they can be borrowed and sold short. The increasingly broad array of index ETFs is creating new risk management approaches that, until now, were available to large institutional investors only. The smaller denominations in which index ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.
Indexes are rebalanced on a regular basis (ad hoc, monthly, quarterly, etc), which allows the indexes to maintain their desired characteristics. Index-based ETFs often rebalance concurrently with their underlying indexes. An index-based fund tracks a particular index, so there tends to be less portfolio turnover than with actively managed funds.
Just as equity indexes are based on different combinations of stocks (for example, the Standard & Poors 500 versus the Russell 2000), fixed income indexes are based on different combinations of fixed income securities. Generally, these fixed income indexes can represent various maturity ranges, bond ratings, or liquidity characteristics. For example, the Lehman Brothers 1-3 Year Treasury Index is a capitalization-weighted combination of publicly-issued, fixed-rate US Treasury securities (non-convertible) that have more than $150 million par value outstanding and maturities from one to three years. Since the underlying indexes represent various characteristics, investors with a view on the yield curve can make applicable investments.
The equity and fixed income markets do not always close on the same days. Several times during the year, index-based fixed-income ETFs will trade on US equity exchanges while the fixed-income markets are closed. In addition, US bond markets may only be open for a portion of the US equity trading day. For example, during Columbus Day, although index-based fixed-income ETFs can trade on the AMEX, the US bond markets are closed. These ETFs may trade at a discount or premium based on investor anticipation of bond appreciation the next trading day.
This phenomenon is similar to observed discounts/premiums in equity index futures before trading in the US equity markets begins. The futures may trade at a discount or premium based on investor anticipation of index appreciation when the equity markets open for trading.
ETFs based on specific indexes may not hold every security in the underlying index. Many indexes contain illiquid or small capitalization securities that are costly to purchase and sell. In order to minimize transaction costs, these ETFs often use optimization techniques to design portfolios that will closely track the underlying index, but not necessarily hold all the securities in the underlying index. However, this strategy may also lead to tracking error.
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