ETNs vs ETFs Part Two: Understanding Exchange Traded Funds

In our first article of this two part series, we talked about ETNs, their advantages and why they are so lucrative for high risk investors. Now we’ll take look at the older sibling to ETNs --- Exchange-Traded Funds, briefly known as ETFs.

So what are ETFs? Exchange-Traded Funds are physical securities traded on stock exchanges, like stocks but not. Like stocks, ETFs are security certificates authorizing partial ownership over a group of stocks. As a result, ETFs require a fund manager to look over the investment for the participants. The manager runs the ETF like any other fund whether mutual or index. All of the known exchanges in the U.S. have ETFs which include

All the major stock indexes have ETFs including the NASDAQ, S&P500 and the Dow Jones Industrial, which means ETFs are regulated by the SEC.

ETF originated in 1993 in the U.S. and in Europe in 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs making them investment vehicles unto themselves.

How are ETFs generated?

ETFs are great for the financial firms that create them because they can play the front-end by amassing a basket of stocks that make up the fund, and the fund manager ears fees at both end. On the back-end they generate investor demand for the fund. The reality is that running an ETF is for the big boys such as Barclays and The Vanguard Group. They’re able to convince pension funds and other funds to loan stocks for the establishment of the ETF.

Setting up an ETF commences with a market maker, also known as an authorized participant. These investment specialists are the cornerstone of the ETF creation process because integrity is critical with the creation of an ETF. These middlemen do the physical assembly of stocks that make up the ETF basket. Upon completion of the assembly, they are sent to a pre-determined custodial bank where they are held in trust. Traditionally, the baskets contain a sufficient number of shares ranging from 10,000 to 50,000. The custodial bank insures the basket meets the original standards set by the fund manager, and ultimately transfers the shares to the authorized participant. The trade off must be ‘’in-kind’’ which does not require capital gains for investors. Thus, investors enjoy exceptional tax advantages investing in ETFs.

The stock basket is held by the custodial bank in the fund manager’s designated account so that the manager can supervise the basket, and of course, the custodial bank earns a nice fee. The basket then is certified by the Depository Trust Clearing Corp., the government agency that keeps track of the sale of stocks transaction in the U.S. The DTCC tracks the transfer of ETF shares similar to any stock shares. The DTCC is the safety net to protect against fraud.

This flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the same US government agency that records individual stock sales and keeps the official record of these transactions. It records ETF transfer of title just like any stock. It provides an extra layer of assurance against fraud.

As soon as the fund manager takes possession of the basket of shares from the custodial bank, the fund manager is able to market and sell the ETC to prospective investors. After that, the ETF is sold on its market exchange.

With all the fees being earned by each participant in the ETF creation process, the process flows with transparency and at a low cost. The requirements make it clear that all of the fees be disclosed in advance.

How Mutual Funds and ETFs Differ

ETFs are created for the largest companies in the U.S., and even smaller ones, real estate investment trusts, emerging market stocks, even some commodities. Any security that can be grouped, or basket-ed, can essentially be turned into an ETF.

The difference between ETFs and mutual funds is that orders for mutual funds are traded at the close of the market each day and comprise the closing day price of all of the stocks within the mutual fund. ETFs, on the other hand, trade in real-time, at the time of the order, during an entire day’s trading. This gives investors the control to lock in an order price instead of having to wait to discover the order price like mutual funds.

For frugal investors, ETFs are a cost effective investment and account maintenance fees back to the fund manager are nominal as low as .09% of fund assets. Conversely, mutual fund fees average 1.5%.

Low fees are nice, but the tax benefits are even greater. And with their relative safety and diversification, ETFs are like investing in a particular stock, but better because you’re acquiring a near complete asset class.

One of the downside to investing in ETFs is their complexity. We have only scratched the surface of the education required to fully understand the particulars of ETF investing, so we encourage all investors to learn more to earn the best results. The benefits are worth the education.