Exchange-Traded Funds Chapter 17 Tools & Techniques of Investment Planning Copyright 2007, The...

Exchange-Traded Funds Chapter 17Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• An exchange-traded fund (ETF) is a security representing a basket of stocks or bonds.– They are traded on a stock exchange, similar to individual

stocks.– They are hybrid securities, combining features of closed-end

and open-end mutual funds.

• ETFs represent shares of ownership in funds, unit investment trusts, or depository receipts that hold portfolios of common stocks or bonds that closely track the performance and dividend yield of specific indexes.– Investors can buy or sell an entire portfolio of stocks in a single

security.


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What is it?

• ETFs bear brand names such as Qubes, SPDRs, HOLDRs, iShares, VIPERs, StreetTracks, and Diamonds.– All of them are passively managed, tracking a wide variety of

sector-specific, country-specific, and broad-market indexes.

• Unlike index mutual funds, ETFs are priced and can be bought and sold throughout the trading day using market, limit, or stop-loss orders.– They can also be sold short and bought on margin.


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How does it work?

• An ETF is a portfolio of stocks or bonds.– Made up of “creation units” or shares of the fund– Each day, a portfolio composition file (PCF) is distributed via

major data vendors.• The PCF indicates the portfolio constituents and their respective

weights.

– As specified by the PCF, an ETF offers investors units in a specific portfolio for a specified amount of cash or securities.

• These units can be traded like an ordinary stock in the secondary market.


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How does it work?

• When redeeming a creation unit, an institutional or large investor receives a basket of the underlying securities and a small amount of cash.– Determined by the PCF– Because this redemption does not require ETF managers to

sell stock, no capital gains are realized.

• Individual retail investors typically sell their shares on the secondary market for cash.


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When is the use of this tool indicated?

• Investors who seek to invest in an industry sector or index and who do not want to acquire and manage a multitude of equity stocks in their portfolio.– Low expense ratios and management fees– Index-oriented investors can easily rebalance their portfolio

towards a specific sector or country.

• Traders who want to try to capitalize on anticipated daily movements of broad market baskets of securities, market sectors, or international stocks.


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When is the use of this tool indicated?

• Participants in employer retirement plans who do not have a large selection of mutual funds options to buy passively managed funds or low cost funds, but may have a self-directed brokerage option to buy passively managed ETFs.


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Advantages

• Diversification– ETFs are designed to provide a single investment value for the

aggregate performance of a number of companies representing specific industries, market sectors, or broad market indexes.

– By incorporating several stocks in an index, an investor has a broader number of companies that gives a degree of protection in case the price of one company in the index goes lower.

• Liquidity– ETFs are priced throughout the day and can be bought or sold

at any time like stocks.– Investors can easily easily rebalance their portfolios at a low

cost and take advantage of market trends.


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Advantages

• Redemption Feature– ETF shares are usually redeemed for the underlying securities.

• Generally limited to large institutional investors or very wealthy investors

– ETFs generally trade close to their net asset values due to the market arbitrage opportunities presented by the redemption feature.

– ETFs are more tax efficient because shares can be distributed in-kind when a change occurs in an index.

• Low Cost– ETFs generally do not have a manager or analyst actively

managing the portfolio.• Lower management fees• Lower transaction costs


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Advantages

• Trading Orders– Investors can place various types of orders to automatically

buy or sell units based on price movements or other criteria.• Such orders include stop-loss orders, limit orders, etc.

• Choice – Investors get exposure to portfolios composed of stocks of

their choice.• They can choose a fund that either represents a broad-based

market index, a specific industry sector, or an international sector.


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Advantages

• Tax Efficiency– ETFs can transfer securities out to redeeming shareholders

instead of selling the securities, thus minimizing taxable capital gains.

– This benefit also applies when stocks are removed from an index.– The low stock turnover is also tax efficient.

• Margin– Investors are able to buy ETFs on margin and “leverage” the

investment.

• Short Sales– Investors can sell ETFs “short” to take advantage of anticipated

declines in the market.


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Advantages

• Sales Loads– ETFs involve no sales loads, but brokerage commissions

usually apply.

• Management and Sponsorship Fees– Expense ratios range from 0.09% of the value of the fund to

0.84%.– Since passively managed, active management costs are

absent.

• Cash Flow– ETFs do not have a “cash drag” from uninvested cash in a

rising market because cash flows from new investors are not coming in or out daily.


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Disadvantages

• Market Risk– ETFs are subject to the same market fluctuations as the

underlying securities.

• Commissions– Investors are subject to regular stock commissions.

• Bid / Ask Price Spread– ETFs are sold at the bid price and bought at the ask price.– The spread between the two represents a trading cost in

addition to broker commissions.


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Disadvantages

• Market Price– ETFs can trade at a premium or discount from its net asset

value.• The price may vary slightly from true underlying values of the

securities in the fund.

• Automatic Reinvestment– Income dividends are not automatically reinvested in the fund.

• Most brokerage firms permit investors to direct that certain income dividends be used to automatically purchase additional shares of stock or ETFs for their account at no cost.


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Disadvantages

• Strategies to Offset Operating Expenses– ETFs do not employ index mutual fund strategies for reducing

tracking error such as the lending of securities on margin to earn income that will offset the fund’s expense ratio.

• Dividends Cash Drag– ETFs structured as unit investment trusts can have a lower return

because of the accounting treatment for income dividends.

• Investing an Exact Dollar Amount– An individual may not be able to fully invest 100% of the cash

he/she has available.• ETFs must be purchased in share amounts rather than dollars.• Odd-lot share amounts (less than 100 shares) or uneven increments

may be more expensive to trade.


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Tax Implications

• Stock can be distributed to ETF shareholders for redemption, and the transaction does not cause the realization of any capital gains.

• ETF managers can assign low-cost stocks to the redeeming shareholders, leaving high-cost stocks in the portfolio holdings.– Provides an exit strategy that minimizes capital gains

• When these high-cost stocks are later sold, smaller capital gains will be realized.

• ETFs establish their cost basis as the original purchase price plus commission, with no pending unrealized tax liability.– Investors buying into an index mutual fund may be buying into a

pending unrealized tax liability.


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Tax Implications

• Nontaxable Entity– A company qualifies as a “regulated investment company” for tax

purposes if it: • Derives at least 90% of its taxable income from dividends, interest and capital

gains from sales of securities, and• Invests at least 50% of its total assets in cash or securities, but no more than

25% of its total assets are invested in the securities of any one issuer

– A regulated investment company is not subject to federal income tax to the extent its taxable income has been distributed to its shareholders in a timely manner.

• The “required distribution” is 98% of the taxable income.• The difference between the required distribution and the income actually

distributed is subject to income tax plus a 4% excise tax.

– All current ETFs qualify as regulated investment companies and pay no federal income tax.


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Tax Implications

• Capital Gains / Losses– Short-term capital gains and losses offset each other to arrive at

net short-term gains or losses.– Long-term capital gains and losses offset each other to arrive at

net long-term capital gains or losses.– If the netting results in a situation where there are net short-term

capital gains and net long-term capital gains, these gains are passed through and taxed to the investor.

• Whether a gain or loss is long- or short-term when passed though to investors depends on how long the securities have been held by the trust; not the length of time the shareholders have held the creation units

– The tax treatment also depends on whether the ETF unit holder (investor) is a corporation or not.


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Tax Implications

• Individual Taxpayer– Utilization of the netting process at the investor level– Short-term capital gains are taxable as ordinary income.

• Short-term capital losses are treated as ordinary losses deductible up to $3,000 per year until used up.

– Long-term capital gains are taxable at the preferential long-term capital-gain tax rate, which is currently 15%.

• Long-term capital losses are deductible up to $3,000 per year until exhausted.

– If both the short- and the long-term netting produce losses for an individual taxpayer, no more than $3,000 of these losses may be deducted per year.

• Any excess losses are carried forward every year until used up.• Net short-term capital losses are used first


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Tax Implications

• Corporate Taxpayer– Both short- and long-term capital gains are taxed at ordinary

income tax rates, but not to exceed 35%.– Both short- and long-term capital losses are nondeductible.

• They can be carried back 3 years and carried forward 5 years to offset capital gains, but not ordinary income.

– If the ETF trust distributes cash dividends to a corporate taxpayer, the corporation may be entitled to a dividends-received deduction.


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Tax Implications

• Distributions from income and capital gains are taxable only to the extent of the ETF’s current and accumulated earnings and profits.– If the ETF distributes taxable income of more than the trust’s

current and accumulated earnings and profits, the excess distribution is treated as a return of investment capital.

• The shareholder’s adjusted basis is reduced.

• If a shareholder’s adjusted basis is reduced to zero, any additional distribution is treated as capital gain.


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Tax Implications

• In-Kind Redemptions– Shareholders may request redemption from the ETF.– The trust may distribute securities and cash approximating the

proportion of the entire portfolio holdings.– Due to an exemption from the general rule, gains from the

securities distributed to the ETF shareholders are not taxable.• Losses are not deductible on the part of the distributing trust.• Termed an “in-kind redemption” and is tax-free

– When the ETF shareholder receives the securities, his adjusted basis in the securities received is the same as his adjusted basis was for his prior interest in the distributing trust.

• Gains or losses are recognized only when the securities are sold.


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Alternatives

• Open-End Mutual Funds– Track the same broad-market indexes, market sectors, and

international markets and indexes tracked by ETFs

• Closed-End Investment Companies– Not as numerous as mutual fund offerings

– Track broad-market indexes, market sectors, or broad international indexes or single-country indexes similar to ETFs


Investment Planning


Alternatives

• Futures Contracts– For aggressive investors who would like to invest in highly margined

ETFs, futures contracts on the same indexes tracked by the ETFs would give them the highest potential margin and the highest potential gain.

• Portfolio Management– Investors with substantial resources can buy the underlying securities

of their desired index directly in the market in proportion to their weight in the index and reproduce the index fund in their own portfolio.


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Where and How do I get it?

• ETFs can be purchased through any brokerage account.


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What fees or other costs are involved?

• Low annual expenses• Investors must pay a commission to buy and sell ETF

shares.• Management Fees

– Since most ETFs are passively managed, management fees are much lower than a typical mutual fund’s fees.

– The Wall Street Journal reported that the weighted average management fee for the 31 largest ETFs was 0.1727% in 2001.


Investment Planning


How do I select the best of its type?

• The real key to selecting the best ETF is to pick a type that meets the investor’s objectives.– Many ETFs track major market indexes

• Examples: The S&P 500 Index, the Wilshire Index, etc..• Permits investors to track indexes of large or small capitalization

value or growth stocks as well as international stock indexes.• Benefits investors who use them to create and rebalance portfolios

– Many focus on a particular sector of the market• Examples: Technology, health care, particular securities of a single

foreign country, etc.• Benefits investors who possess exceptional skill and knowledge in

some particular sector


Investment Planning


How do I select the best of its type?

• Experience– Many ETFs are new and have very little history with which to

judge their efficacy.

• Expenses / Expense Ratios– Any difference in expenses between investment vehicles

tracking the same index is a “dead weight” loss to the vehicle with the higher expenses.

• Other considerations:– Fund expenses– Commissions– Transactions costs (including the bid/ask spread)– Investment style


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Where can I find out more about it?

• Brokerage Houses• Morningstar (www.morningstar.com)• NASDAQ (http://quotes.nasdaq.com/asp/ETFsHome.asp)• Creators of ETFs

– www.amex.com– www.HOLDRS.com– www.iShares.com– www.spdrindex.com/spdr/express.asp– www.streettracks.com– http://flagship2.vanguard.com/VGAapp/hnw/fundsextradedfunds

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