Exchange traded funds

How ETFs are related to Mutual funds

Exchange traded funds or otherwise known as ETFs are close cousins of mutual funds; mutual funds are a basket of securities customized in accordance with investors' investing profile based on their goals (capital preservation and/or growth), time horizon tolerance of risk and prior experience as well as their anticipation of market conditions. Banks' wealth management teams offer a wide variety of funds following a detailed discussions with their clients in relation to their overall investing profiles.

Why do mutual funds exist and what do they serve?

Use of mutual funds is engendered from investors' need of diversification as per portfolio management theory; greater exposure to a variegated set of securities is far more likely to protect investors from perpetually evolving market conditions in light of interest rates and need for liquidities among other factors.

Open ended vs close ended funds

Like other securities; mutual funds are valued based on their closing prices or net asset vales or simply NAVs. It is not uncommon for discrepancies to exist between individual securities' closing price at their respective exchanges and mutual funds' NAVs (this is also the case with ETFs as we will read later on). Mutual funds can be open ended or closed ended funds, with the former there is no limit to the number of shares that can be created and thus enables a new investor to enter seamlessly into funds. Whereas with the closed ended funds a limited number of units (or shares) are issued in the form of IPOs which can be later sold by the investor in the secondary when she wishes to exit the investment for any reason.

How are ETFs different from mutual funds

In order to comprehensively understand ETFs it is important to understand the dynamics of mutual funds, with mutual funds anytime an investor retires their investment; it triggers a tax burden for other fellow investors who partook in the investments. It surely depends on the individual investors' tax jurisdiction and other factors like their main income levels but these taxes usually arise from capital gains and are beyond other investors' control to avoid it. So anytime an investor in the fund decides to exit their investment, it triggers a tax bill for other investors without their discretion. In addition, the mutual funds are not traded in exchanges causing an absence of liquidity, mutual funds are usually offered by brokerage banks and banks.

Whereas ETFs have three important actors; investor, broker and authorized participant or AP. ETFs are also a basket of a variety of different securities like mutual funds however they are created by an authorized participant who amalgamates securities based on a particular investment mandate (like mutual funds), however the transactions related to ETF units' creation or redemption involve a creation and redemption basket and these transactions don't involve exchange of money. Although ETFs are created in primary markets they are also transacted in secondary markets; let's suppose an investor wishes to purchase certain units of an ETF; they would get in touch with their broker with their order, the broker themselves would not have any possession of the ETF so they would coordinate with the AP, APs have the discretion for determining the particulars of the basket required for creation or redemption of ETFs, AP would relay the broker with the information about securities required to create a unit of an ETF. Upon purchasing those securities or basket, broker delivers those securities to AP and claims possession of the ETF unit and later on fulfils their clients' order by delivering them the ETF unit with an additional spread. On the contrary, when an investor wishes to relinquish their ETF units; they again relay a sale order, their broker broker surrenders those ETF units and attain the securities that are part of redemption basket from APs, brokers can consequently sell those redemption in the open market and relay the proceeds to the investors (minus their fees). Brokers make the market by transacting in the market and assuring prices remain within a tight band and as a result compensate themselves through the spreads charged in the form of transaction and management fees (some of these fees are dependent upon investors' holding period like management fees).

APs, on the other hand, play an integral role in sheltering investors from taxes. This is done by determining securities that have the lowest cost base (bought at lowest prices and have appreciated by a noticeable amount causing capital gains taxes if sold conventionally). These dynamics are a major source of avoiding capital gains tax bills for other investors and thereby don't disadvantage other investors when a particular wishes to enter or exit the fund.

ETF applications

I'm very grateful if you've read this far, upon reaching this far I'm sure it begs the question why do investors go into ETFs and what kind of investors benefit from this kind of investment vehicle?

ETFs can be held by individual investors who like to indulge in passive investing where a fund tracks a performance of a particular index like S&P, DOW Jones or Russel without directly buying the many individual constituents that are part of index, passive strategies enable investors to naturally save costs and gain direct exposure to an index of their choice.

In addition ETFs also have active portfolio management applications where portfolio managers can use it for tactical reasons like calculated exposures to a particular factor (like alpha/beta, a particular commodity or access to liquidity), for parking excess cash rather than have it sit idle, attain liquidity as per their investment mandate or engage in inverse investing where investors when the underlying index falls.

Determining factors when choosing an ETF

Upon determining the motive for gaining exposure to an ETF and the underlying respective index, investors face a myriad of options for the ETFs, factors that are crucial for picking the right ETF and making sure they attain most value for their investments consisting of fees (lower the better), tracking error; often times it is impossible to replicate the index completely for cost reasons and hence their exists an optimal number of securities to include in the ETF to assure reasonable mimicking of the index and finally the presence of securities in international exchanges; equities that are traded outside US have their proxies in US exchanges in the form of American depositary receipts or ADRs, these ADRs have discrepancies in their values due to difference in operating hours between exchanges (Sydney vs Hong kong, London vs New York, so on and so forth), the greater international exposures the higher discrepancy to occur between the ETF and underlying index.

Disclaimer; The article is based on my understanding of the investment vehicle and the primary purpose to help people understand it as well as reinforce my understanding of it. I'm not claiming complete understanding and thus will welcome feedbacks in the form of comments.