Exchange-traded funds (ETFs) have been lauded as one of the most transformative innovations in modern asset management. As a vehicle, they’ve enabled investors to access diversified pools of securities with the single click of a button, at any point in the trading day.
What is an ETF and how does it work?
An ETF is a type of investment vehicle that’s similar to a mutual fund because it can provide diversification, but unlike a mutual fund, it trades like a stock. Investors can purchase and sell ETF shares at the current market price in the secondary market, like a stock exchange where most stock trading occurs.
Benefits of ETFs
The ETF vehicle has distinctive features that make it a popular choice among some investors, including:
- Tax efficiency
- Intraday liquidity
- Streamlined fee structures
Tax efficiency: ETFs are often known for being tax-efficient vehicles, largely because the ETF issuer is able to reduce the potential for realizing capital gains when raising cash to meet investor redemptions. This is made possible by a unique mechanism known as the creation/redemption process. When a large redemption occurs, the ETF issuer can use in-kind transactions (trading securities that the ETF holds in exchange for shares that are being redeemed). The authorized participant (AP) delivers the securities back to the secondary market, which avoids selling fund holdings and helps limit capital gains. Of course, ETF investors will pay tax on any capital gains realized when they sell their ETF shares. Because of this, ETFs may be a good choice for investors with taxable accounts who want to have more control over their annual tax liability.
Intraday liquidity: ETFs trade like a stock in that they can be bought and sold anytime during the trading day at market price, which may be at a premium or discount to the net asset value (NAV). This can be helpful for investors who want more control over the timing of their investments.
Streamlined fee structure: The ETF fee structure typically only includes fees that go directly to the investment manager for the investment and business services provided and doesn’t typically include fees for external distribution partners.
Types of ETFs
ETFs may be passive or active. Generally, passive, or index, ETFs offer the opportunity to participate in-line with market returns, while active ETFs use active management to pursue better-than-market returns and greater downside protection.
Passive ETFs aim to track the risk/return profile of an index. Passive ETFs may provide exposure to a broad market index or to a niche index (such as those offering exposure to specific countries or sectors). The ETF may do this by mirroring index holdings or by selecting a subset of holdings that may produce a similar risk/return outcome.
Active ETFs feature active management, meaning the ETF manager (or team) uses an investment strategy to select the fund’s holdings to pursue better-than-market outcomes for investors. Like passive ETFs, active ETFs can offer broad diversification to the overall market, a specific sector, or they may be thematic (designed to express a particular market viewpoint or focus on a specific investment objective). Generally, active ETFs are available in three different structures: transparent, semi-transparent, or non-transparent, which differ in frequency and degree of holdings disclosure as well as the types of securities they can hold.
The ever-evolving ETF landscape
For many investors, from individuals, to advisors, to institutions, the ETF vehicle has become an increasingly important tool in their asset allocation framework, particularly for taxable client assets. And as ETFs have grown in popularity, they’ve continued to evolve. Today, nearly 30 years after the first ETF was introduced to the market in 1993, the product landscape is expanding from one that primarily packaged index, or passive, management to one that offers the benefits of the investment vehicle alongside professional active management.