CETF

How large is the ETF market in the U.S.?

As of the end of 2022, total assets in U.S.-listed ETFs exceeded $6.5 trillion with a vast array of ETF options available.

Which company leads in the number of ETFs and assets under management?

BlackRock's iShares is the leader, capturing roughly 1/3 of the total U.S. ETF market.

What unique challenge do fixed income ETFs face in terms of premiums and discounts?

Fixed income ETFs can exhibit more significant premiums and discounts due to the bond market's complexity and lower liquidity, making it harder for APs to arbitrage away the differences quickly.

How are Grantor Trusts regulated?

Grantor Trusts are SEC-registered investment companies governed by the Securities Act of 1933, but are not regulated by the Investment Company Act of 1940 or the CFTC.

What is unique about grantor trust ETFs?

Grantor trusts typically invest in currencies or physical commodities, with fixed holdings, and offer investors direct interest in the underlying assets.

What is the Intraday Optimized Portfolio Value (IOPV)?

IOPV, also known as the Indicative Intraday Value (IIV) or Indicative Net Asset Value (INAV), represents the intraday value of the ETF and is published during trading hours to reflect the ETF's intrinsic value.

What could cause an ETF to trade at a discount?

If investors rapidly sell ETF shares, possibly during a market selloff, the share price can fall more quickly than the price of the underlying assets, leading to a discount.

How is a UIT different from mutual funds and ETFs?

UITs have a fixed portfolio selected at inception that does not change until the trust matures, offering transparency and tax efficiency with lower costs, but no trading activity like mutual funds or typical ETFs.

What are the key characteristics of UITs?

UITs offer investor protections under various acts, issue redeemable securities, make a one-time public offering, have a termination date, and typically do not actively trade the securities within the trust.

How do unit investment trust ETFs operate?

Unit investment trusts track broad asset classes without reinvesting dividends or capital gains, holding them until distribution to shareholders, usually quarterly.

How is trading an ETF different from a mutual fund?

Unlike mutual funds which can only be bought and sold once a day at the end of trading, ETFs can be traded at any time during market hours.

How do ETNs differ from traditional bonds?

Unlike traditional bonds, ETNs do not provide coupon payments or maturity features like principal protection; their return is based solely on the performance of the underlying index.

What happens when a UIT terminates?

When a UIT terminates, the remaining investment portfolio securities are sold and the proceeds are distributed to the investors. The termination date is often linked to the maturity of the investments within the UIT.

What are trading costs associated with ETFs?

While ETFs can be traded throughout the day, they often incur brokerage fees each time they are traded, similar to individual stocks. Some brokerage firms offer ETFs with zero transaction fees to mitigate this cost.

Do ETF shares represent actual ownership of the underlying securities?

Yes, ETF shares represent a fractional ownership in the holdings making up the creation unit, and these shares are held in trust.

Can open-end ETFs be non-diversified?

Yes, open-end ETFs can file as non-diversified funds, which allows fund managers to invest a larger portion of the fund's assets in fewer positions, up to 50% in a single concentrated position.

Can additional shares of a CEF be created after the IPO?

Yes, while the initial number of CEF shares is fixed, additional shares can be issued through secondary offerings, rights offerings, or the issuance of shares for dividend reinvestment.

What causes ETF market prices to deviate from the NAV?

ETF prices can deviate from the NAV due to market action, such as investor sentiment, volatility, or demand. A price above NAV is a premium, and below NAV is a discount.

How do mutual funds compare to ETFs in terms of tracking error?

Mutual funds may also experience tracking error, often with a higher chance than ETFs due to higher management fees and cash drag from holding cash for redemptions.

How does the traditional mutual fund redemption mechanism affect investors' tax implications?

Mutual funds may distribute capital gains if they sell high-cost basis securities to accommodate redemptions, which can trigger tax events for all shareholders at the end of the year.

Why might an ETF trade at a premium during a buying frenzy?

In a buying frenzy, ETF prices may rise faster than the underlying securities' prices due to high demand, creating a temporary premium.

What was the first ETF created in the U.S. and what does it track?

The first U.S. ETF was the SPDR S&P 500 (ticker symbol 'SPY'), introduced in 1993, tracking the S&P 500 Index.

What are the premiums/discounts in ETF trading?

In fast-moving markets, ETFs can trade at values above (premiums) or below (discounts) their net asset value (NAV), which can lead to potential losses for investors, unlike mutual funds that trade at NAV at the end of the trading day.

How do nontransparent active ETFs differ from typical ETFs?

Introduced in 2020, nontransparent active ETFs feature portfolio opacity with varying disclosure periods, unlike the majority of U.S.-listed ETFs which are fully transparent.

What rights do investors in a Grantor Trust have?

Investors receive dividends directly, have voting rights associated with the securities, and can request stock certificates upon redemption in round lots for each company in the trust.

How do investors transact with mutual funds?

Investors send cash to a mutual fund company and receive mutual fund shares in return. They cannot trade shares throughout the day; all transactions are processed at the NAV after the market closes.

What is the bid/ask spread in ETF trading?

The bid/ask spread is the difference between the price buyers are willing to pay (bid) and the price sellers are asking for (ask) on the exchange. This spread can affect the cost of trading ETFs, especially those with lower trading volumes.

What is the impact of the ETF creation/redemption mechanism on capital gains?

The creation/redemption mechanism of ETFs helps to maintain tax efficiency by avoiding the realization of capital gains that can occur with mutual funds during index reconstitution or rebalancing.

How does ETF creation/redemption benefit investors?

The creation/redemption process helps ETFs trade close to their net asset value, minimizes the risk of capital outflows causing forced sales, and maintains tax efficiency by systematically rebalancing holdings.

What is a key risk factor in ETNs?

The credit rating of the note issuer is a significant risk factor for ETNs, as it affects the value of the note, which can deviate from the value of the underlying index.

What types of ETFs are available in the market?

The market offers plain vanilla, index-tracking ETFs, smart beta, thematic ETFs, derivatives-based funds, and actively managed ETFs, among others.

What determines the market price of a CEF?

The market price of a CEF is determined by supply and demand, not just by the sum of the values of the fund's underlying components (NAV).

How does the ETF creation/redemption mechanism address premiums and discounts?

The mechanism allows Authorized Participants (APs) to arbitrage differences between the ETF's market price and its NAV by creating or redeeming shares, thus minimizing these price variances.

How does the composition of a Grantor Trust change?

The original composition of a Grantor Trust remains fixed unless the stocks it holds become more concentrated due to mergers or acquisitions.

What happens to the underlying securities of an ETF share?

The underlying components remain in the trust until the ETF shares are redeemed, at which point the AP can exchange ETF shares for the actual underlying securities.

Why were these regulatory acts established?

These acts were passed in response to the 1929 stock market crash and the Great Depression to establish a more stable regulatory framework for the financial markets and to help prevent future market crashes and economic turmoil.

How do these acts affect the operation of ETFs today?

These acts, along with their amendments, govern how ETFs operate, including their creation, trading, and disclosure practices, to ensure transparency and protect investors.

What is a Grantor Trust in the context of ETFs?

A Grantor Trust is an ETF structure typically used for commodities, such as gold or silver, and currencies. It holds a fixed basket of securities that doesn't rebalance, and investors have a direct interest in the underlying basket.

What is a Portfolio Composition File (PCF) in the context of ETFs?

A PCF is a document that ETF companies publish after market close which lists the exact names and quantities of underlying securities and cash required for an Authorized Participant (AP) to create a creation unit.

What is a "Unit Investment Trust" (UIT)?

A UIT is a type of investment company that holds a fixed portfolio of securities, such as stocks or bonds, which are purchased and sold through brokers. The trust issues shares (or "units") that represent an undivided interest in the portfolio's income and principal, and dividends are paid out as a lump sum.

How do expense ratios affect tracking error?

A higher expense ratio can lead to a higher tracking error because it reduces the net returns of the ETF, diverging from the performance of the index it tracks.

How do stop-loss and stop-limit orders work with ETFs?

A stop-loss order sells the ETF when it falls below a specific price. A stop-limit order sells at a specific price or better, but only if the ETF trades at that price or higher before the sale is triggered.

How does the investment strategy of a typical CEF compare to an ETF?

A typical CEF employs an actively managed investment strategy and its NAV may vary from its market price, whereas ETFs often track an index with a passive management strategy.

How does the bid/ask spread affect the cost of trading an ETF?

A wider bid/ask spread typically means higher costs for the trader, as it indicates a larger difference between what buyers are willing to pay and what sellers are asking for the ETF shares.

What happens if there's a discrepancy between the ETF price and its underlying assets?

APs can arbitrage the difference, buying or selling ETF shares to capitalize on the price difference between the ETF shares and the underlying securities, which can lead to the creation or redemption of ETF shares.

What role do Authorized Participants play in the ETF market?

APs facilitate the creation and redemption of ETF shares by providing the underlying securities or exchanging them for ETF shares, and they can engage in arbitrage by trading discrepancies between the ETF and its underlying assets.

How are ETF shares redeemed?

APs redeem ETF shares by delivering them to the ETF sponsor in exchange for the underlying securities, often when they need to liquidate their holdings, which is processed on a one-for-one basis at the fund's net asset value.

What is an ETF?

An ETF, or Exchange-Traded Fund, is an investment vehicle much like mutual funds, offering diversified access to different areas of the market. It can be bought and sold throughout the trading day under a single ticker.

What is an arbitrage opportunity in the context of ETFs?

An arbitrage opportunity occurs when APs can buy the underlying securities for less than the ETF's share price or vice versa, and profit from the difference after adjusting for transaction costs.

Who uses the Portfolio Composition File and why?

Authorized Participants use the PCF to know what assets they must deliver to the ETF sponsor to receive ETF shares. ETF managers ensure that PCFs are sent to the National Securities Clearing Corporation (NSCC) for distribution to APs.

What are other structures that an Exchange-Traded Product (ETP) can have?

Beyond open-end funds, ETPs can also be structured as unit investment trusts, grantor trusts, partnerships, and exchange-traded notes. The specifics of these structures are detailed in subsequent sections.

How are CEFs traded?

CEF shares are bought and sold on national exchanges, with transactions occurring between investors, not with the fund sponsor, similar to stocks or ETFs.

What is the key difference between ETFs and Closed-End Funds (CEFs)?

CEFs issue a fixed number of shares through an IPO and do not typically allow for the creation of new shares post-IPO, which can lead to shares trading at a premium or discount to the NAV, unlike ETFs which have a continuous creation/redemption process.

How do ETFs compare to traditional bond mutual funds in reflecting costs?

Costs in ETFs are reflected real-time in the share prices, while costs in traditional bond mutual funds get reflected in the NAV and are distributed among all shareholders, potentially causing a lag in price adjustment.

How are ETF shares created?

ETF shares are created when Authorized Participants (APs) exchange a basket of underlying securities with the ETF sponsor in a process known as 'in-kind' creation, matching the ETF's portfolio without generating new shares through investor purchases.

How does an ETF create shares?

ETF shares are created when an AP delivers a basket of securities that matches the ETF's holdings to the ETF sponsor. In return, the AP receives new ETF shares.

How are ETF shares typically sold?

ETF shares are usually sold in the open market on an exchange. Investors holding enough shares to constitute a creation unit may exchange them directly with the AP for the underlying securities.

How are ETFs taxed compared to mutual funds?

ETFs are generally more tax-efficient due to their unique creation and redemption process leading to fewer taxable events.

What is the tax efficiency feature of ETFs?

ETFs are more tax efficient than mutual funds due to the creation/redemption mechanism that typically does not trigger a capital gains event, as it is considered an in-kind exchange that the IRS does not tax.

What is the tax advantage of ETFs compared to mutual funds?

ETFs benefit from a more favorable tax treatment, allowing long-term capital gains treatment, because in-kind redemptions by APs do not trigger capital gains distributions as with mutual funds.

What makes ETFs unique compared to mutual funds?

ETFs can trade on exchanges throughout the day, leading to key differences in liquidity and tax efficiency compared to mutual funds.

How are ETF expenses typically lower than those of actively managed funds?

ETFs generally have no entry or exit fees, lower management fees, and they avoid certain costs associated with supporting and marketing large actively managed funds.

How are ETFs tax-efficient compared to traditional mutual funds?

ETFs have a creation/redemption mechanism that usually does not trigger a capital gains event, allowing them to routinely expunge low-cost-basis holdings and minimize capital gains distribution exposure.

How do ETFs minimize capital gains distributions?

ETFs minimize capital gains distributions by expunging low-cost-basis holdings during routine redemption, which does not result in taxable capital gains like mutual funds might incur during rebalancing.

What kind of diversification do ETFs provide?

ETFs offer portfolio diversification as they can hold a vast array of securities within a single fund, providing a mix of equities, bonds, alternatives, and derivatives to investors.

What is the primary trading flexibility advantage of ETFs?

ETFs offer the ability to be bought and sold throughout the trading day, sold short, purchased on margin, and investors can use limit and stop-orders, enhancing trading strategies.

What are the cost benefits of investing in ETFs?

ETFs often have lower expense ratios compared to actively managed mutual funds due to lower internal fund operating costs and lack of load or redemption fees.

What does "asset class coverage" refer to in the context of ETFs?

ETFs provide access to a wide range of asset classes, allowing investors to diversify across different assets, themes, and strategies for comprehensive portfolio construction.

How does diversification work in the context of ETFs?

ETFs provide diversification by trading like single stocks but holding a basket of multiple securities, allowing for a mix of equities, bonds, alternatives, and derivatives in a single portfolio.

What are exchange-traded notes (ETNs)?

ETNs are debt instruments tied to the performance of a specified index, minus expenses, and have set maturity dates, but do not offer principal protection.

What are Exchange-Traded Notes (ETNs)?

ETNs are senior, unsecured, unsubordinated debt securities that are traded on an exchange. They are tied to the performance of a market index, commodity, or currency, minus fees, and do not offer principal protection or coupon payments.

What is an Exchange-Traded Note (ETN) and how does it relate to tracking error?

ETNs are unsecured debt obligations that seek to mimic the return of an underlying index without owning the actual assets. They reduce tracking error but introduce credit risk of the issuer as an additional risk.

Can ETNs make distributions?

ETNs may or may not make distributions from their benchmarked index, and any distributions are not considered qualified dividends.

What is a primary benefit of investing in ETNs?

ETNs typically do not experience the tracking errors common in other exchange-traded products, and they may offer more favorable tax treatment than other structures.

What situations can exacerbate ETF price-to-NAV divergences?

Extreme market stress or outages can lead to larger and more persistent premiums or discounts, similar to what might occur with closed-end funds.

Why are stop-loss and stop-limit orders beneficial for ETF investors?

These orders help investors lock in profits, limit losses, and manage risk during market volatility, as they can be executed at precise price points.

What flexibility do open-end fund ETF managers have?

They have the flexibility to modify fund holdings to meet investment objectives and can invest in securities not included in the tracked index.

What is the process to redeem mutual fund shares?

To redeem shares, investors must sell them back to the mutual fund company, which may sell securities from its portfolio to provide the cash for redemptions, often maintaining a cash buffer for this purpose.

What is tracking error in ETFs?

Tracking error is the difference between the performance of the ETF and the index it aims to track. It can be affected by the ETF's expense ratio, diversification rules, and other factors such as dividend lag.

What is the first step for an ETF provider in the share creation process?

The ETF provider must file a registration statement with the SEC. Once approved, they form an agreement with an Authorized Participant (AP) to create and redeem ETF shares.

How is the IOPV used in ETF trading?

The IOPV allows Authorized Participants to arbitrage differences between the NAV of the ETF's components and the ETF's trading price, ensuring the ETF trades close to its net asset value.

How is the NAV of a mutual fund calculated?

The NAV (Net Asset Value) is calculated by dividing the total value of the securities in the fund by the total number of shares outstanding. For example, if a mutual fund holds securities worth $535,000 and there are 10,000 shares, the NAV would be $53.50 per share.

What SEC diversification rules can impact ETFs?

The SEC enforces diversification rules that prevent ETFs from holding more than 25% of their total assets in a single security, which can sometimes lead to tracking errors for specialized or thematic ETFs.

What is the significance of the SPY ETF?

The SPY ETF gave investors transparent, low-cost, and tax-efficient access to the S&P 500 index and is one of the most heavily traded securities in the world.

What acts provide the regulatory framework for ETFs?

The Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940 form the foundational regulatory framework for ETFs and other ETPs.

Can you give an example of an ETF that offers broad diversification?

The Vanguard Total Stock Market ETF (VTI) and the iShares Core U.S. Aggregate Bond ETF (AGG) are examples, with VTI holding over 3,400 companies and AGG representing nearly 9,300 different bonds.

How do liquidity and trading hours affect ETF premiums and discounts?

Liquidity issues and trading hours, particularly with ETFs holding international stocks that trade in different time zones, can lead to premiums or discounts due to a disconnect between market price and NAV.

What type of structure do most ETFs have?

Most ETFs are structured as open-end management investment companies, similar to mutual funds, but with certain exemptions from the SEC.

What is the transparency level of most ETFs?

Most ETFs offer daily transparency of their underlying holdings, unlike mutual funds which report quarterly and with a possible delay of up to 60 days.

What level of transparency do ETFs offer?

Most ETFs report their underlying holdings on a daily basis, providing a high level of transparency to investors, unlike mutual funds which report quarterly and often with a delay.

What do most ETFs track and how are they managed?

Most ETFs track an index and are known as passively managed vehicles, often with lower fees compared to actively managed funds.

What is the cash drag in mutual funds?

Mutual funds typically keep a cash reserve to meet redemption requests, which can reduce the fund's overall investment potential - this is known as 'cash drag'.

Are ETF shareholders affected by the creation/redemption process?

No, ETF shareholders are not impacted by the creation/redemption activity, as this occurs at an institutional level between APs and the ETF sponsor.

Does a UIT have a board of directors or corporate officers?

No, UITs do not have a board of directors or corporate officers and are regulated primarily under specific sections of the Investment Company Act of 1940 and the Securities Exchange Act of 1934.

What is a nontransparent active ETF?

Nontransparent active ETFs, introduced in 2020, provide less frequent disclosure of holdings, adding an element of portfolio opacity, contrasting with the full transparency of most ETFs.

What are the investment strategies of open-end ETFs?

Open-end ETFs can use derivatives and portfolio optimization to minimize tracking errors and can reinvest dividends automatically for shareholders.

What are the characteristics of open-end fund ETFs?

Open-end funds provide exposure to stocks or bonds and can reinvest dividends and interest immediately. They are regulated under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940.

What defines partnership ETFs?

Partnership ETFs are usually involved in commodities futures, require shareholders to report income, gains, and losses on tax returns, and are generally regulated by the CFTC.

What are the implications of not being able to trade mutual fund shares throughout the day?

Positions in a mutual fund can only be established or liquidated at the end of the day, which may impact investors' flexibility and potentially their investment strategy, particularly in volatile markets.

When might premiums and discounts persist in ETFs?

Premiums and discounts may linger if APs face obstacles like time zones, structural problems, or liquidity issues, or when the arbitrage opportunity does not sufficiently cover transaction costs.