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ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the day on stock exchanges, whereas mutual funds are bought and sold from the issuer based on their price at day’s end. ETFs are also more transparent since their holdings are generally published online daily and, in the United States, are more tax efficient than mutual funds.
Unlike mutual funds, ETFs trade on a stock exchange, can be sold short, can be purchased using funds borrowed from a stockbroker (margin), and can be purchase and sold using limit orders, with the buyer or seller aware of the price per share in advance. Both ETFs and mutual funds charge annual expense ratios that range from 0.02% of the investment value to upwards of 1% of the investment value.
Mutual funds generally have higher annual fees since they have higher marketing, distribution and accounting expenses (12b-1 fees). ETFs are also generally cheaper to operate since, unlike mutual funds, they do not have to buy and sell securities and maintain cash reserves to accommodate shareholder purchases and redemptions. Stockbrokers may charge different commissions, if any, for the purchase and sale of ETFs and mutual funds.
In addition, sales of ETFs in the United States are subject to transaction fees that the national securities exchanges must pay to the SEC under section 31 of the Securities Exchange Act of 1934, which, as of February 2023, is $8 per $1 million in transaction proceeds. Many mutual funds can be bought commission-free from the issuer, although some charge front-end or back-end loads, while ETFs do not have loads at all.
In the United States, ETFs can be more attractive tax-wise than mutual funds for transactions made in taxable accounts. However, there are no tax benefits to ETFs compared to mutual funds in the United Kingdom and Germany. In the US, whenever a mutual a capital gain that is not balanced by a realized loss (i.e. when the fund sells appreciated shares to meet investor redemptions), its shareholders who hold the fund in taxable accounts must pay capital gains taxes on their share of the gain.
However, ETF investors generally only realize capital gains when they sell their own shares for a gain.ETFs offered by Vanguard are actually a different share class of its mutual funds and do not stand on their own; however, they generally do not have any adverse tax issues. ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds, which can only be traded at the end of the trading day.
Also unlike mutual funds, investors can execute the same types of trades that they can with a stock, such as limit orders, which allow investors to specify the price points at which they are willing to trade, stop-loss orders, margin buying, hedging strategies, and there is no minimum investment requirement. ETFs can be traded frequently to hedge risk or implement market timing investment strategies, whereas many mutual funds have restrictions on frequent trading.
Options, including put options and call options, can be written or purchased on most ETFs – which is not possible with mutual funds, allowing investors to implement strategies such as covered calls on ETFs. There are also several ETFs that implement covered call strategies within the funds. Many mutual funds must be held in an account at the issuing firm, while ETFs can be traded via any stockbroker. Some stockbrokers do not allow for automatic recurring investments or trading fractional shares of ETFs, while these are allowed by all mutual fund issuers.
The most popular ETFs such as those tracking the S&P 500 trade tens of millions of shares per day and have strong market liquidity, while there are many ETFs that do not trade very often, and thus might be difficult to sell compared to more liquid ETFs. The most active ETFs are very liquid, with high regular trading volume and tight bid-ask spreads (the gap between buyer and seller’s prices), and the price thus fluctuates throughout the day. This is in contrast with mutual funds, where all purchases or sales on a given day are executed at the same price at the end of the trading day.
Issuers are required by regulators to publish the composition of their portfolios on their websites daily, or quarterly in the case of active non-transparent ETFs. ETFs are priced continuously throughout the trading day and therefore have price transparency. Most ETFs are index funds: that is, they track the performance of an index generally by holding the same securities in the same proportions as a certain stock market index, bond market index or other economic index.
Examples of large Index ETFs include the Vanguard Total Stock Market ETF (NYSE Arca: VTI), which tracks the CRSP U.S. Total Market Index, ETFs that track the S&P 500, which are issued by The Vanguard Group (VOO), iShares (IVV), and State Street Corporation (SPY), ETFs that track the NASDAQ-100 index (Nasdaq: QQQ), and the iShares Russell 2000 ETF (IWM), which tracks the Russell 2000 Index, entirely composed of companies with small market capitalizations.
Other funds track indices of a certain country or include only companies that are not based in the United States; for example, the Vanguard Total International Stock Index ETF (VXUS) tracks the MSCI All Country World ex USA Investable Market Index, the iShares MSCI EAFE Index ETF (EFA) tracks the MSCI EAFE Index, and the iShares MSCI Emerging Markets ETF (EEM) tracks the MSCI Emerging Markets index. Some ETFs track a specific type of company, such as the iShares Russell 1000 Growth ETF (IWF), which tracks the “growth” stocks in the Russell 1000 Index.
State Street Corporation has issued ETFs that track the components of the S&P 500 in each industry: for example, the Technology Select Sector SPDR Fund (XLK) tracks the components of the S&P 500 that are in the technology industry and The Financial Select Sector SPDR Fund, which tracks the components of the S&P 500 that are in the financial industry. The iShares Select Dividend ETF replicates an index of high dividend paying stocks.
Other indexes on which ETFs are based focus on specific niche areas, such as sustainable energy or environmental, social and corporate governance. Most index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called replication.
Some index ETFs such as the Vanguard Total Stock Market Index Fund, which tracks the performance of thousands of underlying securities, use representative sampling, investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund’s adviser believes will help the ETF to achieve its investment objective.
Factor ETFs are index funds that use enhanced indexing, which combines active management with passive management in an attempt to beat the returns of an index. Factor ETFs tend to have slightly higher expense ratios and volatility than strictly passive index ETFs. Synthetic ETFs, which are common in Europe but rare in the United States, are a type of index ETF that does not own securities but tracks indexes using derivatives and swaps.
They have raised concern due to lack of transparency in products and increasing complexity; conflicts of interest; and lack of regulatory compliance. A synthetic ETF has counterparty risk, because the counterparty is contractually obligated to match the return on the index. The deal is arranged with collateral posted by the swap counterparty, which arguably could be of dubious quality. These types of set-ups are not allowed under the European guidelines, Undertakings for Collective Investment in Transferable Securities Directive 2009 (UCITS).
Counterparty risk is also present where the ETF engages in securities lending or total return swaps. The difference between the performance of an index fund and the index itself is called the tracking error; this difference is usually negative, except during flash crashes and other periods of extreme market turbulence, for index funds that do not use full replication, and for indices that consist of illiquid assets such as high-yield debt.
Actively managed ETFs include active management, whereby the manager executes a specific trading strategy instead of replicating the performance of a stock market index. The securities held by such funds are posted on their websites daily, or quarterly in the cases of active non-transparent ETFs. The ETFs may then be at risk from people who might engage in front running since the portfolio reports can reveal the manager’s trading strategy. Some actively managed equity ETFs address this problem by trading only weekly or monthly.
The largest actively managed ETFs are the JPMorgan Equity Premium Income ETF (NYSE: JEPI), which charges 0.35% in annual fees, JPMorgan Ultra-Short Income ETF (NYSE: JPST), which charges 0.18% in annual fees, and the Pimco Enhanced Short Duration ETF (NYSE: MINT), which charges 0.36% in annual fees.
Thematic ETFs are ETFs, including both Index ETFs and actively managed ETFs, that focus on a theme such as disruptive technologies, climate change, shifting consumer behaviors, cloud computing, robotics, electric vehicles, the gig economy, e-commerce, or clean energy. Bond ETFs are exchange-traded funds that invest in bonds. Bond ETFs generally have much more market liquidity than individual bonds. Commodity ETFs invest in commodities such as precious metals, agricultural products, or hydrocarbons such as petroleum and are subject to different regulations than ETFs that own securities.
Commodity ETFs are generally structured as exchange-traded grantor trusts, which gives a direct interest in a fixed portfolio. SPDR Gold Shares, a gold exchange-traded fund, is a grantor trust, and each share represents ownership of one-tenth of an ounce of gold. Most commodity ETFs own the physical commodity. SPDR Gold Shares (NYSE Arca: GLD) owns over 40 million ounces of gold in trust, iShares Silver Trust (NYSE Arca: SLV) owns 18,000 tons of silver,Aberdeen Standard Physical Palladium Shares (NYSE Arca: PALL) owns almost 200,000 ounces of palladium, and Aberdeen Standard Physical Platinum Shares ETF (NYSE Arca: PPLT) owns over 1.1 million ounces of platinum.
However, many ETFs such as the United States Oil Fund by United States Commodity Funds (NYSE Arca: USO) only own futures contracts,[74] which may produce quite different results from owning the commodity. In these cases, the funds simply roll the delivery month of the contracts forward from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll. They can also be index funds tracking commodity indices.
Currency ETFs enable investors to invest in or short any major currency or a basket of currencies. They are issued by Invesco and Deutsche Bank among others. Investors can profit from the foreign exchange spot change, while receiving local institutional interest rates, and a collateral yield. Leveraged ETFs (LETFs) and Inverse ETFs, use investments in derivatives to seek a daily return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of an index.
For example, Direxion offers leveraged ETFs and inverse exchange-traded funds that attempt to produce 3x the daily result of either investing in (NYSE Arca: SPXL) or shorting (NYSE Arca: SPXS) the S&P 500. To achieve these results, the issuers use various financial engineering techniques, including equity swaps, derivatives, futures contracts, and rebalancing, and re-indexing. The rebalancing and re-indexing of leveraged ETFs may have considerable costs when markets are volatile. Leveraged ETFs effectively increase exposure ahead of a losing session and decrease exposure ahead of a winning session.
This is called volatility drag or volatility tax. The rebalancing problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. Leverage possesses a dual nature, as it has the potential to result in substantial profits, yet it also carries the risk of substantial losses. Cryptocurrency ETFs invest in cryptocurrencies such as Bitcoin, Ethereum, or a basket of different cryptocurrencies.
There are two types of crypto ETFs. Spot crypto ETFs invest directly in cryptocurrencies, tracking their real-time prices, and their share prices will fluctuate with the prices of the cryptocurrencies they hold. On the other hand, future-based crypto ETFs refer to equities that do not invest directly in cryptocurrencies but rather in crypto futures contracts. These contracts are agreements to buy or sell cryptocurrencies at a predetermined price in the future. As a result, the share prices and price fluctuating trends of funds in these two types could be different, even though they hold identical cryptocurrencies and amounts.
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