An exchange-traded fund ETF is a type of pooled investment security that operates exactly as a mutual fund. Typically, exchange-traded funds track a particular index, sector, commodity, or other asset. However, unlike mutual funds, exchange-traded funds can be purchased or sold on a stock exchange market the simple way of investing into a regular stock.
Going back on October 19th, 1987 the date that is better known as Black Monday, the Dow Jones Industrial Average DJIA declined by more than 24 percent within a single day. It marked the most significant stock market decline in the history of the financial exchange market. In response to the stock market crash, the Security Exchange Commission SEC in the United States was assigned to investigate the event. Consequently, it published a report analyzing the causes of the collapse.
A key finding in the Security Exchange Commission’s SEC report was that index futures and program trading caused the crash.
The results, published by the Security Exchange Commission SEC in 1987 recommended for introduction of a single product, enabling investors to trade a whole basket of securities on an exchange market. The report results led to the introduction of ETFs in 1993. Then, the first product in the United States to offer this unique feature was introduced by Standard & Poor’s Depositary Receipt SPDR on January 23rd, 1993.
However, unlike the mechanism of fund investment, where the market is open-end and closed-end, ETFs are traded continuously on an exchange. Moreover, as ETFs do not keep track of individual shareholders, the average expense ratio for ETFs is 0.1 percent, compared to 0.3 percent for index funds. These additional features make ETFs attractive for small investors as well as large institutions, who want to gain exposure to a broad market.
ETFs Market
The superiority of ETFs is reflected in a continuously increasing market share, particularly at the costs of index futures and index mutual funds. For instance, within the past 15 years, total assets of ETFs have twenty-folded, whereas active mutual funds grew by 130 percent. Until 2020, over 6’400 ETFs are traded worldwide with total assets over 3.7 trillion USD. In the United States, seven ETFs are among the ten most frequently traded securities.
Exchange-traded fund ETFs are considered to be the fastest growing investment product worldwide. Within 15 years, total assets invested in ETFs reached over 3.7 trillion USD by the end of 2018. Increasing demand for passive investments, coupled with high liquidity and low transaction costs, are key advantages of ETFs compared to their closest substitutes, such as traditional index funds.
Dependent on the replication methodology, ETFs can either be classified as physical or synthetic. Physical ETFs hold the underlying securities, such as stocks or bonds, physically. Whereas synthetic ETFs use total return swaps to replicate the price of the index. Synthetic ETFs are the only predominant in the money market and commodity asset classes. It is often stated that synthetic ETFs are exposed to additional counterparty risk, as the ETF sponsor is required to enter a total return index swap with a counterparty.
In contrast, physical ETFs engage in security lending, therefore being similarly exposed to counterparty risk. In 2016, historical data showed that the average lending fees of ETF sponsors were as high as their expense ratio. Today, over 80 percent of ETFs’ total assets are invested in physical ETFs.
Independent of the distinction between physical and synthetic ETFs, the underlying architecture of both types can similarly be subdivided into a primary and a secondary market. The primary ETF market consists of the ETF sponsor (provider, manager) and the so-called Authorized Participant AP, usually a market-maker or large financial institution.
In the primary market, ETF providers such as Blackrock, ProShares and Vanguard enter into legal contracts with Authorized Participants, which in turn interact directly with the financial market. ETF providers can create newly issued shares when the Authorized Participant deposits the underlying basket to the sponsor or what is considered to be share creation.
Following share creation, the Authorized Participant can hold newly created ETF shares or sell them on an exchange or on what is considered to be a secondary market. Shared redemption work the other way around. The Authorized Participant redeems shares by transferring ETF shares to the ETF sponsor, receiving in return the underlying securities.
The creation basket specifies the shares and the number of shares that the Authorized Participant needs to deposit to the ETF sponsor. Notice that there can be multiple Authorized Participants interacting with the ETF provider, on average, each ETF provider has 34 Authorized Participants.
The above mentioned ETF structure gives rise to a unique arbitrage mechanism. Imagine ETF shares being traded at a premium to Net Asset Value NAV. The Authorized Participant can realize arbitrage profits by investing in the underlying stocks, delivering them to the ETF provider and receiving newly created ETF shares in exchange. Selling ETF shares on the secondary market puts downward pressure on the shares resulting in alignment between NAV and the price of ETF shares.
Similarly, when ETF units are priced below NAV, the Authorized Participant buys ETF shares and redeems them for the underlying securities. An Authorized Participant is not required to realize such arbitrage profits. High-frequency investors can similarly capitalize on the divergence between ETF share prices and the NAV, by merely short selling the expensive and buying the cheaper assets.
This type of statistical arbitrage accounts for 50 percent of the S&P500 ETF trading volume. During trading days, ETF sponsors publish their NAV every 15 seconds, fostering arbitrage activity and lowering tracking errors.
For synthetic ETFs, the arbitrage mechanism on the secondary market is the same as for physical ETFs. In contrast to physical ETFs, the synthetic ETF provider is required to enter a total return swap with a counterparty.
Index Funds Compared to ETFs
In 2020 over 25 percent of the assets held by investment companies were held in the form of passive index funds and passive exchange traded funds. Furthermore, many indexes are followed by multiple passive fund strategy. As empirical evidence shows that active funds underperform passive indexes by about 75 basis points.
Given these facts, it is important for investors to understand how to make the choice between index funds and ETFs for any particular index. Our purpose is to explain what affects performance and how to choose between passive vehicles.
- In the first part of the paper, we examine return pre-expenses which measures management’s performance. On average, ETFs pre-expenses slightly outperform the index they follow, while index funds slightly underperform.
- We examine the factors that account for differences in the performance of index funds and ETFs relative to the indexes they follow. Cross-sectionally, the major factors affecting pre-expense performance for index funds are turnover, the number of passive funds in the same category, and the return from security lending. When we examine the standard deviation of return differences from the index they follow, the main determinant is the type of index followed, with emerging market indexes and foreign stock indexes having the largest deviations.
For ETFs, the major determinants of differential returns across funds following the same index are the number of passive funds in the same category and the amount of security lending they do.
In general, the standard deviation of deviations from the index is primarily determined by which index they follow, although security lending also plays a role. When we examine what determines cross-sectional return post expenses, the same factors matter. However, the expense ratio becomes much more important in affecting differential return.
- We examined the choice between two alternatives: the lowest cost index fund and the lowest cost exchange traded fund. If the investor followed a strategy of selecting either the index fund or ETF each period, whichever had the lower expenses, the investor would be better off by 5 basis points per year compared to always selecting the ETF while the performance of retail investors would be unchanged.
- We then examine how to pick the best ETFs and the best index funds separately. We have two criteria, expense ratio and expense ratio plus the return from the significant factors affecting pre-expense return. Picking the lowest expense index fund rather than the average index fund improves returns by 33 basis points next year for institutional investors and 38 basis points per year for retail investors.
For ETFs, the difference is 5 basis points per year since there are fewer choices. For index funds, 82 percent to 85 percent of the funds have lower returns in the following year compared to the lowest expense fund and for 60 percent choosing the lowest expense fund has the highest performance of all alternatives in the next period, with the number of funds available averaging 10 funds.
The results are similar when we consider performance over a three year rather than a one-year period. Taking into account the factors affecting pre-expense return improves performance but given the much larger effect of expenses, the improvement is very small.
What are the Advantages of investing in ETFs
Following are the advantages of ETFs over other financial investments
- Investing in ETFs provides investors with the advantage of a variety of stocks, bonds, and other assets, typically at a lower expense.
- Investing in ETFs takes the potential risks of out-of-stock investing. It allows investors to match the market’s performance over time, which has historically been quite strong.
- ETF assets are more liquid, therefore are easier to buy and sell compared to mutual funds. Online investment mechanisms ease the way ETFs are bought or sold.
- A bond ETF portfolio makes the fixed-income portion much easier than a complicated individual bond investment.
- To learn more about ETF investments, you can purchase THE FIRST INVESTOR book and receive a discount by clicking on The First Investor.