A Primer on Exchange-Traded Funds

CPAs should know the difference between ETFs and mutual funds.
BY PHYLLIS J. BERNSTEIN

EXECUTIVE SUMMARY
SINCE THE AMERICAN STOCK EXCHANGE INTRODUCED them in 1993, the market for exchange-traded funds continues to grow despite the current disappointing investment climate. As an alternative to index mutual funds, ETFs offer investors a low-cost, tax-efficient way to invest in their favorite market segments. The expense ratio for most ETFs is much lower than for mutual funds, even with the commission investors pay to buy and sell shares.

ETFs ENABLE INVESTORS TO TRADE “THE MARKET” with a single investment as easily as if they were buying an individual stock. Most ETFs are unit investment trusts and represent a portfolio of common stocks that closely track the performance of a specific index—either broad market, sector or international.

ETFs DIFFER FROM MUTUAL FUNDS in how shares or units are issued and redeemed and how they trade. ETF shares are created when an institutional investor deposits a specified block of securities with the fund. Individual retail investors can buy and sell shares only after they are listed on an exchange.

THE TAX IMPLICATIONS OF ETFs ARE IDENTICAL to those of ordinary stock. Since redemptions by large investors are paid in kind, an ETF is more tax efficient than ordinary mutual funds because it doesn’t have to sell stock at a gain to meet the redemption.

BECAUSE ETF SHARES ARE EASY TO BUY AND SELL, an investor should beware of the temptation to buy and sell too often, which could eliminate any tax or cost advantages. Clients who make regular trades may find the commissions overwhelming and be better off with traditional mutual funds.

PHYLLIS J. BERNSTEIN, CPA/PFS is president of Phyllis Bernstein Consulting, Inc., in New York City, which advises CPA/financial planners. She previously served as director of the AICPA personal financial planning division. Her e-mail address is Phyllis@PBConsults.com .
 
espite the disappointing performance of last year’s broad market indices, the demand for exchange-traded funds (ETFs) continues to grow. ETFs may well be the hottest investment product of the new century. An alternative to index mutual funds, they offer investors a low-cost, tax-efficient way to track their favorite market segments. As more ETFs are introduced, CPAs will soon be able to find one for most countries, regions and U.S. market indexes and sectors. Before CPA/financial planners can explain—and recommend—these complex investments to their clients however, they must educate themselves about the characteristics of ETFs and how they work.
INVESTMENT HYBRID

An ETF is an index investment crossed with an exchange-listed corporate security and an open-ended mutual fund. They enable investors to trade “the market” with a single investment as easily as if they were buying an individual stock. ETFs represent ownership of a portfolio of common stocks that closely track the performance of a specific index, either broad market, sector or international. In an active secondary market, individual investors can buy or sell as little as a single ETF share during trading hours. By contrast, traditional mutual funds generally can be purchased or redeemed only at the end of the trading day.

While ETFs compete with index mutual funds for investor dollars, they have a very different operational structure. Most ETFs are unit investment trusts: A UIT is an investment company with a finite life that raises capital from investors and uses the proceeds to buy a fixed portfolio of securities. ETFs trade throughout the day over an exchange, and investors can buy or sell shares through a broker or in a brokerage account just as they would shares of any publicly traded company. ETFs have low expense ratios ranging from .18% to .25%. An additional cost to investors is the “spread” between the bid and ask prices, which can amount to over 1% of the purchase or sale price. Although ETFs have low expenses, investors do pay a brokerage commission on a per-trade basis to buy or sell them. See “What’s in a Name?” below, for some of the unusual names ETFs trade under.

ETF Assets on the Rise

At the end of 2000, overall exchange-traded fund assets totaled $65.6 billion, compared to $6.9 trillion for mutual funds. By October 2001, assets in exchange-traded funds had grown to $69.4 billion.

Source: Investment Company Institute, Washington, D.C., www.ici.org.

HOW ETFs WORK

While an ETF is registered with the SEC as an investment company—either as an open-end fund or a UIT—it differs from a mutual fund both in how shares or units are issued and redeemed and in how they are traded. (See the exhibit at the end of this article.) Unlike mutual funds and UITs, ETF shares are created when an institutional investor (someone who manages money for institutions and corporate investors such as retirement plans or endowment trusts) deposits a block of securities with the ETF. In return for this deposit, the investor receives a fixed number of ETF shares, some or all of which it may then sell on a stock exchange.

What’s in a Name?

ETFs are known by a variety of sometimes quirky names—Spiders, Diamonds, OPALs, WEBS (now iShares), Qubes, VIPERs, HOLDRs and StreetTracks are just a few. The biggest institutional players in ETFs are State Street Global Advisors, the Bank of New York and Barclays Global Investors. The American Stock Exchange launched the first ETF in 1993, with Standard and Poor’s Depository Receipt Trust, called SPDR 500 or Spiders. Currently there are 90 ETFs listed on the AMEX with nearly $75 billion under management, not including HOLDRs.

Morgan Stanley created OPALs—Optimized Portfolios of Listed Securities—in 1994. Listed on the Luxembourg Stock Exchange, they represent Morgan Stanley’s Capital International (MSCI) indexes and are marketed primarily to institutional investors.

The SPDR is the most widely traded and well-known ETF. Created in 1995, the mid-cap SPDR tracks the S&P Mid-Cap 400 Index. Diamonds, which track the Dow Jones Industrial Average, were added in 1998. NASDAQ later introduced Qubes, named after its ticker symbol, QQQ, to track the NASDAQ 100 Index. WEBS (World Equity Benchmark Shares now called iShares), mirror foreign equity market indices. HOLDRs, a new product trading on the AMEX, issues depository receipts that represent individual and undivided ownership interests in the common stock of companies involved in a specific segment of a particular industry.

In May 2001 Vanguard began offering its exchange-traded class of shares called Vanguard Total Stock Market VIPERs. The only fund to track the Wilshire 5000 Total Market Index, Vanguard expects its VIPERs to have an annual expense ratio of 0.15% ($15 per year on a $10,000 investment)—the lowest of any ETF tracking the broad U.S. stock market.

The institutional investor can get its deposited securities back by redeeming the same number of ETF shares it got from the fund. (See “Creating an ETF” below for more details.) Individual investors can buy and sell ETF shares only when they are listed on an exchange. Unlike an institutional investor, an individual investor cannot purchase or redeem shares directly from the ETF as he or she could with a mutual fund.

Creating an ETF

Exchange-traded funds are generally created in response to anticipated demand for a fund to track a particular market index or industry such as the Nasdaq 100 or the Wilshire 5000. When this happens, an institutional investor or large intermediary such as Barclays Global Investors or State Street Global Advisors—known as an authorized participant (AP)—transfers a portfolio of stock that closely approximates the specified index to a fund manager. The manager places the stock in a trust and issues ETF shares to the AP. It is free to hold the new securities or sell them to other investors.

The ETF shares trade freely between investors on established stock exchanges (the American Stock Exchange is a major player in ETFs). Small investors generally sell their shares for cash to another investor. When an institutional investor with large ETF holdings decides to exit an ETF, the securities are retired in block-sized units. The institution gets shares of the stock or stocks underlying the ETF plus some cash representing accumulated dividends.

Depending on the kind of ETF or the index being tracked there may be minimum requirements to create the fund. For example a unit of 50,000 shares is required to create Diamonds while a 25,000-share unit is required to create mid-cap SPDRs.

Investors can buy ETFs on margin (subject to the same rules that apply to common stocks) at limit prices and sell them short in a brokerage account. Certain ETF products are even exempt from the rule that requires shares to be sold short only on an uptick in price. None of this holds true for a mutual fund.

Creation units. Unlike mutual fund distributors, ETF sponsors do not sell shares to the public for cash. Instead they exchange large blocks of ETF shares—called creation units—for the securities of the companies that make up the underlying index plus a cash component representing mostly accumulated dividends. Some institutional investors or wealthy individuals may hold the creation units in their own portfolios. Others, generally broker-dealers, break up the units and offer the ETF shares on the exchanges where individual investors can buy them in their brokerage accounts through a broker or an online trading account.

ETFs are redeemed in a way that is the opposite of how they are created. Broker-dealers buy enough ETF shares from individual investors to make a creation unit block. They then exchange the block with the ETF sponsor for a “basket” of securities and a small amount of cash. Other institutional investors simply trade back the creation units in their portfolio to the ETF sponsor for securities and cash.

Sponsors continually create and redeem creation units based on investor demand and for arbitrage purposes. An ETF’s value tracks closely but does not match exactly the value of the underlying security, so institutional investors can measure the price of the underlying securities in the index against the price of the ETF. If the price of the underlying securities is higher than the ETF, the institutional investors will trade a lower priced creation unit back to the sponsor in exchange for the higher priced securities. Conversely, if the price of the underlying securities is lower than the ETF, the institutional investor will trade the lower priced securities back to the fund in exchange for a creation unit. This arbitrage mechanism eliminates a problem sometimes associated with closed-end mutual funds—the fund’s trading for more or less than the value of the underlying portfolio.

THE TAX CONSEQUENCES

As with any investment, CPAs should consider the tax consequences of ETFs to individual investors. Essentially, the tax implications are identical to those for ordinary stock. If a client sells in less than one year, any gain will be taxed as ordinary income. If the client sells at a gain after a year, he or she will be taxed at lower capital gains rates. If the fund loses value, investors can write off the loss against other capital gains (and up to $3,000 annually of ordinary income) when they sell.

In taxable accounts, ETFs are more tax efficient than ordinary mutual funds. Investor sales can force mutual fund managers to sell stock to meet redemption requests. This can result in the fund’s paying a taxable capital gain to shareholders—even at a time when the overall market is trending down. In an ETF, nothing in the underlying portfolio changes when an investor buys or sells individual shares. Most trading takes place between shareholders. The fund doesn’t need to sell stock to meet redemptions so it avoids realizing a gain on its holdings. During periods of heavy redemptions, ETFs avoid selling the underlying stock holdings by transferring securities to redeeming shareholders, typically large investors or institutions. Because these investors are paid “in kind” with stock, not cash, other shareholders are protected from a taxable event. However, ETFs can and do make capital gains distributions. These usually result when the ETF must buy and sell stocks to adjust for changes in its underlying benchmark (the index the ETF tracks).

Current shareholders of mutual funds pay taxes on distributions, while former shareholders—who may have benefited from the gains that created the distributions—do not. ETFs, on the other hand, use a swapping feature to eliminate embedded capital gains from the portfolio. Each security the ETF holds has a tax basis, and the fund distributes the lowest-cost-basis securities in its portfolio during the redemption process. The redeeming investor is responsible for taxes, and the ETF ends up with a higher-tax-basis portfolio and fewer capital gains to distribute—reducing capital gains exposure for investors when the fund must sell a particular stock during rebalancing. Whenever an investor redeems a basket of securities, the fund gives that redeemer the lowest-cost-basis stock. It doesn’t matter to the redeemer, which pays taxes based on its individual cost basis, not the basis of the underlying stock.

TOO GOOD TO BE TRUE?

So what’s the catch? Is there a downside for investors CPAs should know about? To begin with, greater tax efficiency doesn’t necessarily mean 100% tax efficiency. ETFs still pay out dividends and any gains that arise from changes in the composition of the indexes they track—just as open-end mutual funds do. While some ETFs—such as Qubes—have made few or no distributions so far, others make distributions annually.

The biggest catch for investors stems from one of the major attractions of these funds—that they can be bought and sold so easily by calling a broker or accessing an online trading account. An investor who is tempted to buy and sell often could eliminate any tax or cost advantages. Unfortunately, statistics suggest ETF investors are doing just that. While the typical mutual fund is held three years, the average holding period for SPDRs in the first five months of 2001 was just 19 days and for Qubes only 4 days. In addition, share prices can diverge from the fund’s net asset value and trade at a premium or a discount—which means a buyer could end up paying more for shares than they were worth. Combined with a brokerage commission, this could negate the lower expenses. In summary ETFs are a good idea for index investors but, just as with mutual funds, CPAs should recommend them only as part of a balanced portfolio and advise clients to acquire them on a long-term, buy-and-hold basis.

Some investors never should use ETFs: If a client makes periodic investments or periodically rebalances his or her portfolio, he or she could end up being “eaten alive” by commissions. From a cost perspective the client would be better off with a mutual fund. If he or she plans to make a single large investment, assuming a low commission (on the buy and sell transactions), CPAs may want to do the math to determine whether the client would be better off putting that money in an index mutual fund.

THE BOTTOM LINE

Why are ETFs so hot? In a nutshell, they are easy to buy, inexpensive to own and tax efficient. Unlike mutual funds, they can be bought and sold throughout the day at real-time prices, sold short and purchased on margin. They can be bought through any broker, which means an investor can further control his or her expenses by using a discount broker. In advising clients, CPAs should caution them to beware of steep sales charges. Initial charges and exit fees typically amount to 2% to 5%. But annual operating expenses are very low. Compare Qubes with an expense ratio of .18% to Rydex OTC, a mutual fund that also seeks to track the Nasdaq 100, at 1.15%, or Vanguard’s Index 500 Trust at .18% with Barclay’s iShares S&P 500 fund at .0945%. ETFs can be significantly more tax efficient than open-end mutual funds because they aren’t subject to the cash flow fluctuations. This is helping generate significant investor interest in this relatively new investment vehicle.

When the mad hatter is running the tea party, the best CPAs can do is follow the white rabbit and recommend ETFs where appropriate. But don’t let the excitement of the moment replace good judgment. Once CPAs have completed the asset allocation portion of the financial planning process, they can help clients select a mix of ETFs that meet their goals, risk tolerance and time horizons.

Is there an ETF in your clients’ future? ETFs initially will cut more into sales of individual securities than mutual funds, at least on the retail side. Mutual fund buyers tend to be conservative buy-and-hold investors who don’t have brokerage accounts. It will take time for them to become ETF-savvy, whereas those who actively purchase individual securities will find it more natural to buy ETFs. But perhaps the most interesting angle is that ETFs will bring passive investing to active securities investors.

Exchange-Traded Funds vs. Mutual Funds
  Exchange-Traded Funds Mutual Funds
Trading Buy or sell on exchange during trading hours. Buy or sell at net asset value at the end of the trading day.
Purchase/sale options Trade only through brokers. Sponsors do not sell shares directly to the public. Generally available directly from the fund sponsor. Many mutual funds are available through brokers.
Expenses Operating expenses are generally low. Costs to buy or sell are based on brokerage commission rates plus a spread between bid and ask prices. Mutual funds may be subject to one or more of the following: a sales load paid to the broker who sold the fund, annual management expenses, 12b-1 fees to cover marketing and advertising costs, exit fees when shares are sold and a deferred sales charge intended to discourage frequent trading.
Dividend distributions Rarely made. Typically made quarterly depending on what stocks the fund holds.
Redemptions Broker-dealers buy creation blocks, exchanging them for a basket of securities and some cash. This protects other shareholders from a taxable event. Sponsor sells shares from its portfolio to make cash payments to redeeming shareholders. These transactions typically result in a taxable event to other shareholders.
Tax consequences Same as for traditional stocks based on long- or short-term holding period. Sales taxed like traditional stocks based on investor cost basis and holding period. Mutual fund shareholders also receive dividend and capital gains distributions based on fund holdings.
Commissions/sales load Standard brokerage commissions to buy and sell. Some funds carry a sales load as an adjustment to the purchase price.

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