What are exchange traded funds?
I. EXCHANGE TRADED FUNDS BASICS :
Exchange traded funds (ETFs) are relatively new and currently only one percent of investor assets are invested in them. Most of the players are frequent traders, and not buy and hold investors. As investors become more familiar with the characteristics of ETFs, they will draw assets away from conventional mutual funds and index funds. In the United States, there are about 125 ETFs valued at over $105 billion, representing popular indexes, international indexes and various sectors of the market. This valuation is still a pittance compared to the $6 trillion invested in mutual funds. Almost all ETFs are listed on the American Stock Exchange (AMEX), except for three international ETFs listed on the New York Stock Exchange (NYSE) and two listed on the NASDAQ.
II. DEVELOPMENT AND GROWTH OF OPEN END ETFs:
The early development and growth of open end exchange traded funds coincided with a period of dramatic change in the financial markets. Part of the reason for the success of ETFs being, that they are a favorite toy of the poster child of the financial market revolution- the on-liner trader. Share prices near or over $100 on some of the most successful funds and tight bid asked spreads in a period of high share price volatility have made ETFs a compelling choice for the online trader who pays only nominal per share brokerage commissions and correctly sees the percentage bid asked spread as his principal transaction cost. High trading volume, competitive market makers and active arbitrage pricing, often enhanced by the presence of related derivative products, have made ETFs a logical and sensible choice for active traders and anyone else who wants to participate in short-term stock price moves. At the other end of the trading spectrum, long-term investors have become increasingly sensitive to the issue of fund tax efficiency after large taxable capital gains distributions by conventional mutual funds in the wake of the strong equity markets of the 1990s and the weak markets of 2000 and 2001. The better managed open end ETFs have succeeded in keeping most of their share holder's capital gains in unrealized and hence tax deferred form. Both short and long-term investors are attracted by the low expense ratios of these funds, which are largely a result of eliminating unnecessary shareholder accounting at the fund level.
But there is a disturbing side to the ETF story. An important feature of
recent markets is the relative isolation of many individual investors. Since
the introduction of negotiated commissions in 1975, we have seen a steady
change in brokerage firm economics from the fee for service model to an earnings
model for many financial firms that are based on feed for assets gathered.
Payments made to brokers for customer order flow have often been more valuable
to the traditional broker than the small remaining brokerage commission. Increasingly,
the advisor or representative who has been the investors contact with a full
service brokerage firm shares in a fee linked to the value of the assets in
an account. This asset based charge may be in the form of a service fee associated
with a traditional equity or money market fund, or a WRAP fee, where the investor
pays an asset based fee in return for the right to make trades or receive
advice without a commission on each transaction. The asset gathering and the
account servicing functions may be handled by different employees of a firm.
Employees often work in teams to coordinate customer service. If coordination
among team members is not done well, an investor’s relationship with
important members of the team may be transitory and unsatisfying.
The discount and deep discount brokerage model where the Stock Exchange Commission registered firm employee, has become an order taker or account statement troubleshooter, that often eliminates any relationship an investor might have with an individual, who would have been a financial advisor or consultant in a full-service brokerage firm. The investor using a discount broker may place orders with an anonymous telephone voice. In this case, the relationship is remote and purely transactional. Aggressive online traders may enter orders on a screen without any human contact at all in the order entry proves, making trading an extremely solitary activity. Commissions are very low, making transactions appear very cheap. In a low transaction cost environment, it is easy to overlook some of the risk exposures linked to more active trading.
As their stock positions turn over more quickly in response to lower trading costs, active traders need a greater understanding of personal risk management and a relationship with someone whose knowledge of markets and securities is complementary to their own. They support this more than ever before. But, just as the need for interaction is increasing, changing industry economics make appropriate personal or business relationships harder to achieve and maintain.
The mutual fund revolution centered on ETFs has just begun. Many new variations on the exchange traded fund theme will appear over the next few years. The opportunity for investors to earn improved after tax returns and to create tax efficient risk reward patterns not possible with other financial instruments makes the case for ETFs compelling, relative to conventional funds. We will examine the critically important investment characteristics of the existing exchange traded funds. Most of these characteristics will still be key features of the new ETF products under development.
III. THE REGULATORY STRUCTURE AND MECHANICS OF THE OPEN ETF
The secret behind the low expense ratio of ETFs: the absence of shareholder accounting at the fund level. Other sections cover the regulatory framework within which the open ETF operates, introduce the transaction and tax cost allocation functions in a kind of fund share creation and redemption process and the arbitrage pricing mechanism, which prevents meaningful premium or discount pricing of fund shares. Fund share creation and redemption will come up again, when we look at tax efficiency and arbitrage pricing issues that appear again in the trading.
IV. INTRA-DAY TRADING
A large faction of the investors who use exchange traded funds place a value on intra-day trading, solely, because it gives them the opportunity to liquidate their position any time of day in an adverse market environment. Even if buying shares in a conventional mutual fund at the net asset value is acceptable to investors, many of them like the idea that with ETFs they do not to sell at the price determined at the close. A smaller group values the ability to use the wide range of types of orders available for the execution of an order in a common stock. More sophisticated investors who have no intention of selling shares in a tumbling market or with complex orders embrace the ETF mechanism because it offers a fairer allocation of trading costs than does the conventional mutual fund structure. To the extent that an investor holds shares in a conventional fund for the long run and the fund does not charge a premium over net asset value to new shareholders or a redemption fee the chances are that the longer term holders of the fund subsidize in and out traders. The ETF structure simply and fairly allocates the cost of trading to those who trade.
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