Understand the structure, mechanics and popularity of ETFs

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Since the creation of the first exchange-traded fund (ETF) in 1993, ETFs have experienced phenomenal growth as an investment vehicle available to retail and institutional investors. In 2021, ETFs in the US were worth US$7.2 trillion.¹

What is behind the continued and growing popularity of ETFs? We believe that the growth is attributable to the advantages obtained by ETF issuers and investors, as well as strategic and structural innovations.

This blog will cover things to know about ETFs before considering a launch:

  • How ETFs Compare to Mutual Funds
  • Behind the scenes: the mechanics of ETFs
  • ETF structural choices
  • The role of the SEC in innovation

Exchange Traded Funds vs Mutual Funds

ETFs are similar to mutual funds in many ways. The two pool investors’ capital. Both invest in a wide range of strategies. Both offer passively managed funds designed to track a specific index and actively managed funds comprised of securities uniquely selected by an investment manager.

But ETFs have some advantages over mutual funds:

  • Exchange-traded and intraday pricing. In keeping with its name, ETFs trade on stock exchanges (NYSE, Cboe, and NASDAQ), while mutual funds must be purchased through other channels, such as brokerage firms. Since ETFs trade on an exchange, they trade throughout the day, providing greater liquidity. Mutual funds, on the other hand, only trade at their daily closing price.
  • Costs. ETFs are generally less expensive than mutual funds.
  • Tax efficiency. ETFs are generally more tax efficient than mutual funds. In a traditional mutual fund, portfolio managers sell portfolio holdings to respond to shareholder liquidations or to rebalance the portfolio. Sales of these securities may generate taxable capital gains which are passed on to shareholders.

In the ETF structure, securities do not always need to be sold to meet investor redemptions. Instead, ETF shares can be traded directly between investors. When redemptions exceed inventory in the secondary market, baskets of assets approaching a pro rata tranche of

ETFs are redeemed in kind and the fund is not required to distribute capital gains from these transactions to the remaining shareholders.

ETFs started out primarily as passively managed funds that track specific indices, but over the past couple of years actively managed ETFs have seen tremendous growth in assets and in the number of new funds coming to market.

ETFs typically provide transparency into their underlying holdings on a day-to-day basis. Some ETFs use a hedging mechanism to show a representative portfolio but hide the true composition of the portfolio.

ETFs are generally not offered on 401(k) channels for a number of reasons. 401(k) infrastructure was developed before ETFs were widely available and the record-keeping systems used in these plans were not designed to handle products that can be traded throughout the day. . ETFs are also not traded in fractional shares, which makes small additional investments difficult. Also, because 401(k)s are tax-deferred, they don’t benefit from the tax efficiency that ETFs offer.

In the wings: The mecanic

The number of shares outstanding in an ETF structure fluctuates daily due to the continuous issuance of new shares and the redemption of existing shares.

The ability of ETFs to issue and redeem shares continuously helps keep the current market price in line with the net asset value of the underlying securities in the portfolio.

The ETF share creation/redemption process is managed between the ETF sponsor and an authorized participant (AP).

The diagram below illustrates the main players and the flow of actions for ETFs.

The ETF structure is most often incorporated as a registered investment company (RIC) professionally managed by a registered investment adviser and regulated by the Investment Companies Act of 1940. As a RIC, an ETF is governed by a board of independent trustees who are responsible for: i) approving contracts, ii) ensuring the fund designs and implements comprehensive compliance policies and procedures, and iii) providing oversight fund operations on behalf of shareholders.

Most ETFs are classified as open-end funds, similar to mutual funds. Nevertheless, structural variety abounds:

Open funds. Most open-ended ETFs are structured like RICs, explained above. Additionally, open-end ETFs are priced daily and allow an investor to buy and sell shares of the fund any day that trading is open. Funds are required to distribute income and capital gains directly to shareholders.

Unit investment trusts (UIT). Some of the earliest exchange-traded funds were set up as unit investment trusts. A mutual fund generally has a fixed portfolio of securities and a fixed term. UITs, like open-ended funds, are governed by the Investment Companies Act 1940. There are, however, some distinctions between the two; UITs do not have a board of directors or an investment advisor.

Exchange Traded Licensor Trusts. Grantor trusts are most often used to form ETFs that hold physical assets, such as precious metals. These products cannot receive income and must hold a specific amount of underlying assets. Investors in these funds are considered direct holders of the underlying asset.

Exchange Traded Notes (ETNs). Exchange-traded notes trade like ETFs on an exchange, but ETNs are unsecured debt securities that typically track an index. ETNs promise to pay an amount equal to the return of the index minus management fees. ETNs carry inherent credit risk because they are considered debt securities and not assets.

The role of the SEC in innovation²

Exempt Relief. In September 2019, the SEC adopted Rule 6c-11 to “…facilitate greater competition and innovation in the ETF market, thereby providing more choice for investors.” The adoption was intended to bring ETFs to market faster without the time and expense of seeking an individual exemption. Prior to the rule’s approval, the SEC had issued more than 300 exemption orders allowing ETFs to operate under the Investment Company Act. One of the conditions of the rule is to disclose the ETF’s daily holdings.

The exemption under Rule 6c-11 only applies to open-end funds.

Semi-transparent/non-transparent ETFs. In May 2019, the SEC granted an exemption under the Investment Company Act of 1940 on a number of applications to allow investment advisers to market ETFs that do not provide daily composition transparency. of the portfolio. These actively managed ETFs, also known as non-transparent or semi-transparent ETFs, allow active portfolio managers to reap the benefits of the ETF structure while hiding or masking the underlying holdings to protect their strategy.

Precidian Investments, the New York Stock Exchange, Fidelity Investments and Blue Tractor were among the advisers who received relief.

ETF Investment Strategies

ETFs come in a multitude of strategies, spanning domestic and overseas markets.

Bond ETFs. Bond or fixed income ETFs offer exposure to one or more bonds, including US Treasuries, corporate, municipal, international and high yield bonds.

Equity ETFs. Stocks or stocks, ETFs hold a portfolio of individual stocks; many are passively managed and track a specific index.

Sector and industry ETFs. These ETFs are designed to provide exposure to a specific sector, such as healthcare, or an industry, such as biotechnology.

Commodities ETF. Commodity ETFs provide exposure to commodities, such as gold. These ETFs generally invest in derivatives that track the underlying value of the commodity rather than directly holding the underlying assets. ETFs that hold physical commodities like gold are usually set up as Grantor Trusts.

ETF-style. Style ETFs are designed to follow a specific investment style or market capitalization, such as large cap value or small cap growth.

Thematic ETFs. These ETFs offer portfolios based on particular themes such as technological advances and social trends.

Currency ETFs. Currency ETFs can be used to hedge a portfolio against currency risk and can invest in a single currency or many different currencies.

ETFs offer investment managers the opportunity to expand their product offerings and attract new investors. For investors, ETFs offer the opportunity to invest in a relatively inexpensive product that offers tax efficiency, transparency and liquidity. ETFs continue to attract large investment flows as the types of investment strategies expand.

Investment managers looking to add ETFs to their product lineup should consider working with an experienced fund administrator to help evaluate ETF structures and provide advice on launching an ETF.

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