Exchange-Traded Funds (ETFs)

What is an Exchange-Traded Fund, or ETF?

An exchange-traded fund (ETF) is a type of investment company whose investment objective is to achieve the same return as a particular market index. An ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. For example, one type of ETF, known as Spiders or SPDRs, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index.

Although ETFs are legally classified as open-end companies or Unit Investment Trusts (UITs), they differ from traditional open-end companies and UITs in the following respects:

• ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as "Creation Units."
• Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase Creation Units are frequently institutions.
• After purchasing a Creation Unit, an investor often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of Creation Units).
• Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.

An ETF, like any other type of investment company, will have a prospectus. All investors that purchase Creation Units receive a prospectus. Some ETFs also deliver a prospectus to secondary market purchasers. ETFs that do not deliver a prospectus are required to give investors a document known as a Product Description, which summarizes key information about the ETF and explains how to obtain a prospectus. All ETFs will deliver a prospectus upon request. ETFs do not use profiles. ETFs that are legally structured as open-end companies (but not those that are structured as UITs) must also have statements of additional information (SAIs). Open-end ETFs (but not UIT ETFs) must provide shareholders with annual and semi-annual reports. Before purchasing ETF shares, you should carefully read all of an ETF’s available information, including its prospectus. (Source: SEC)

Exchange-traded funds (or ETFs) are open-ended collective investment schemes, traded as shares on most global stock exchanges. Typically, ETFs try to replicate a stock market index such as the S&P 500 (SPY) or Hang Seng Index, a market sector such as energy or technology, or a commodity such as gold or petroleum.

The legal structure and makeup varies around the world, however the major common features include:

• An exchange listing and ability to trade continually;
• They are index-linked rather than actively managed;
• Through dynamic and quantitative strategies, these can be dynamic rather than static indexing strategies
• The ability to handle contributions and redemptions on an in-kind basis (typically in large blocks of shares only); and
• Their 'value' (but not necessarily the price at which they trade—they can trade at a 'premium' or 'discount' to the 'underlying' assets' value) derives from the value of the 'underlying' assets comprising the fund.

These qualities provide ETFs with some significant advantages compared with traditional open-ended collective investments. The ETF structure allows for a diversified, low cost, low turnover index investment. This appeals to both institutional and retail investors both for long term holding and for selling short and hedging strategies.

Index Basis

Many current U.S. ETFs are based on some index; for example, SPDRs (Standard & Poor's Depository Receipts, or "Spiders") are based on the S&P 500 index. The index is generally determined by an independent company; for example, Spiders are run by State Street, while the S&P 500 is calculated by Standard & Poor's. Sometimes, a proprietary index is used.

Although the SEC states flatly that an ETF is "a type of investment company whose investment objective is to achieve the same return as a particular market index," this is no longer reality. The development of investment structures has progressed more quickly than the SEC's website.

A series of ETFs introduced by Powershares in 2006 no longer follow the traditional definition. These funds, while correlating to the performance of the S&P 500, NASDAQ 100, DJIA, and S&P 400 Midcap, do not attempt to merely achieve the same return as the underlying index. The twelve funds attempt to either achieve the daily performance of the designated benchmark times two, times negative one, or times negative two. They are ETFs with integrated leverage.

Another example of an innovative ETF that has broken the classic mold is the oil futures ETF: USO. This ETF tracks the performance of the Western Texas Intermediate light sweet crude. This is not a benchmark, but a traded commodity.

Rydex has taken a different direction and worked with S&P to create new, equal-weight benchmarks for their proprietary benchmarks. These "benchmarks" are rebalanced quarterly.

Creation and Redemption of Shares

Rather than the fund manager dealing directly with shareholders, institutional investors will create a portfolio of shares identical to the ETF and loan them to the fund manager. The portfolio is then incorporated in the ETF and ETF shares are created. Typically a creation unit consists of 50,000 shares.

ETF shares are sold and resold freely among large investors on the open market. If they purchase a sufficient amount of shares, the investor can exchange one full creation unit of ETF shares for the underlying shares of stock. The ETF creation unit is then destroyed and the underlying stocks are delivered out of the trust.

The attraction of this method of dealing for the ETF fund manager is that the institutional investors cover the dealing costs in purchasing the required shares to make up the portfolio. The reason they are willing to do this is the profit they can make by arbitrage based on the trading price of shares on the secondary market. Shares will trade at a premium to net asset value if demand is high and at a discount to net asset value if demand is low. These market drivers provide the efficiency for the ETF managers as the bulk buying power of the institutional investors allows them to avoid the expense of mass share creation and deletion.

Today ETFs present a viable alternative investment option to traditional open-ended mutual funds, especially open-ended index funds. There are many available ETFs that attempt to track all kind of indexes (such as large-cap, mid-cap, small-cap, etc), specialties (such as value and growth), industries, countries, precious metals and other commodities or commodity indices like GSCI; and more are being developed for the future.

ETFs vs. Open-Ended Funds

An advantage of mutual funds is that they have lower costs if you only invest a little bit of money, or invest small monthly or quarterly amounts. Since ETFs are traded on the stock market, every trade has commission costs. Many mutual funds do not have such costs. If an investor likes to invest, say, $100 or $500 every month, mutual funds are likely to cost less.

There are many advantages to ETFs, and these advantages will likely increase over time. Most ETFs have a lower expense ratio than comparable mutual funds. Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.

In the US only, ETFs are usually more tax-efficient than mutual funds in some jurisdictions. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to their shareholders by the end of the quarter. This can happen when stocks are added to and removed from the index, or when a large number of shares are redeemed (such as during a panic). These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF on the stock market, as they would a stock), so that investors generally only realize capital gains when they sell their own shares.

Perhaps the most important, although subtle, benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many ETFs have the capability for options (puts and calls) to be written against them. Mutual funds do not offer those features.

For example, an investor in an open-ended fund can only purchase or sell at the end of the day at the mutual fund's closing price. This makes stop-loss orders much less useful for open-ended funds – if your broker even allows them. An ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the ETF for cash throughout regular trading hours, and often after-hours on ECNs. ETF liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid ETFs such as SPY, DIA, and QQQQ can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.

A more subtle advantage is that ETFs, like closed-ended funds, are immune from some market timing problems that have plagued open-ended mutual funds. In these timing attacks, large investors trade in and out of an open ended fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term unit holders. With an ETF (or closed-ended fund) such an operation is not possible--the underlying assets of the fund are not affected by its trading on the market. (Source: Wikipedia)

Mutual Funds

What is a mutual fund?

A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities. Legally known as an "open-end company," a mutual fund is one of three basic types of investment company. The two other basic types are closed-end funds and Unit Investment Trusts (UITs).

Here are some of the traditional and distinguishing characteristics of mutual funds:

• Investors purchase mutual fund shares from the fund itself (or through a broker for the fund), but are not able to purchase the shares from other investors on a secondary market, such as the New York Stock Exchange or Nasdaq Stock Market. The price investors pay for mutual fund shares is the fund’s per share net asset value (NAV) plus any shareholder fees that the fund imposes at purchase (such as sales loads).
• Mutual fund shares are "redeemable." This means that when mutual fund investors want to sell their fund shares, they sell them back to the fund (or to a broker acting for the fund) at their approximate NAV, minus any fees the fund imposes at that time (such as deferred sales loads or redemption fees).
• Mutual funds generally sell their shares on a continuous basis, although some funds will stop selling when, for example, they become too large.
• The investment portfolios of mutual funds typically are managed by separate entities known as "investment advisers" that are registered with the SEC.

Mutual funds come in many varieties. For example, there are index funds, stock funds, bond funds, money market funds, and more. Each of these may have a different investment objective and strategy and a different investment portfolio. Different mutual funds may also be subject to different risks, volatility, and fees and expenses.

All funds charge management fees for operating the fund. Some also charge for their distribution and service costs, commonly referred to as "12b-1" fees. Some funds may also impose sales charge or loads when you purchase or sell fund shares. In this regard, a fund may offer different "classes" of shares in the same portfolio, with each class having different fees and expenses. (Source: SEC)

A mutual fund is a form of collective investment that pools money from many investors and invests their money in stocks, bonds, short-term money market instruments, and/or other securities. In a mutual fund, the fund manager trades the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.

Legally known as an "open-end company" under the Investment Company Act of 1940 (the primary regulatory statute governing investment companies), a mutual fund is one of three basic types of investment companies available in the United States. Outside of the U.S. (with the exception of Canada, which follows the U.S. model), mutual fund is a generic term for various types of collective investment vehicle. In the U.K. and western Europe (including offshore jurisdictions), other forms of collective investment vehicle are prevalent, including unit trusts, open-ended investment companies (OEICs), SICAVs and unitized insurance funds.

Mutual funds can invest in many different kinds of securities. The most common are cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as technology or utilities. These are known as sector funds. Bond funds can vary according to risk (e.g., high-yield or junk bonds, investment-grade corporate bonds), type of issuers (e.g., government agencies, corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and foreign securities (global funds), or primarily foreign securities (international funds).

Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts the future performance of investments appropriate for the fund and chooses those which he or she believes will most closely match the fund's stated investment objective. A mutual fund is administered through a parent management company, which may hire or fire fund managers.

Mutual funds are subject to a special set of regulatory, accounting, and tax rules. Unlike most other types of business entities, they are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are also tax-free to the shareholder. Taxable distributions can be either ordinary income or capital gains, depending on how the fund earned those distributions.

Mutual funds offer several advantages over investing in individual stocks, including diversification and professional management. A mutual fund may hold investments in hundreds or thousands of stocks, thus reducing the risk associated with owing any particular stock. Moreover, the transaction costs associated with buying individual stocks are spread around among all the mutual fund shareholders. Additionally, a mutual fund benefits from professional fund managers who can apply their expertise and dedicate time to research investment options. Mutual funds, however, are not immune to risks. Mutual funds share the same risks associated with the types of investments the fund makes. If the fund invests primarily in stocks, the mutual fund is usually subject to the same ups and downs and risks as the stock market. (Source: Wikipedia)

Money Market and Money Market Funds

What is the money market? What are money market funds?

The money market is the market for short-term debt instruments. (Source: CFTC)

A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money market deposit account" at a bank, money market funds are not federally insured.

Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. They attempt to keep their net asset value (NAV) at a constant $1.00 per share—only the dividend yield goes up and down. But a money market’s per share NAV may fall below $1.00 if the investments perform poorly. While investor losses in money market funds have been rare, they are possible. (Source: SEC)

A money market is a financial market for short-term borrowing and lending, typically up to thirteen months. This contrasts with the capital market for longer-term funds. In the money markets, banks lend to and borrow from each other, short-term financial instruments such as certificates of deposit (CDs) or enter into agreements such as repurchase agreements (repos). It provides short to medium term liquidity in the global financial system. Money market derivatives include forward rate agreements (FRAs) and short-term interest rate futures.

Trading takes place between banks in the "money centers" (New York and London primarily, also Chicago, Frankfurt, Paris, Singapore, Hong Kong, Tokyo, Toronto, Sydney, Mumbai, San Francisco).

Money funds (or money market funds, money market mutual funds) are mutual funds that invest in short-term debt instruments. Money market mutual funds are restricted by quality, maturity and diversity guidelines. They must buy only the highest rated debt with maturies under 13 months and with a weighted average maturity of 90 days or less. They are only allowed to invest up to 5% in any one issuer, with the exception of the government. No individual investors may lose money in a money fund, which keep a stable $1.00 NAV (net asset value), but it is possible for these funds to "break the buck" and decline to $0.99 or less.

Institutional Money Funds

Institutional money funds are high minimum, low expense share classes which are marketed to corporations, governments, or fiduciaries. They are often set up so that money is swept to them overnight from a company's main operating accounts. Large national chains often have many accounts with banks all across the country, but electronically pull a majority of funds on deposit with them to a concentrated money market fund.

The largest institutional money fund is the JPMorgan Prime Money Market Fund, with almost $100 billion in assets as of Dec. 31, 2006. Among the largest companies offering institutional money funds are BlackRock, Federated, Columbia (Bank of America), Dreyfus, AIM and Evergreen (Wachovia).

Retail Money Funds

Retail money funds are offered primarily to individuals with moderate-sized accounts. Their primary use is as temporary holding funds at stock brokerage firms. Retail money market funds hold roughly 40% of all money market fund assets.

Retail money funds invest in short-term debt, such as US Treasury bills and commercial paper, come in a few different breeds: government-only funds, non-government funds and tax-free funds. You will get a slightly higher yield in the non-government variety, which will invest in high-quality commercial paper and other instruments. Money funds for individuals are currently yielding just under 5.0%. However, instruments of the United States Government are usually exempt from state income taxes.

The largest money market mutual fund is Fidelity Investments' Cash Reserves, with assets exceeding $88 billion. The largest retail money fund providers include: Fidelity, Vanguard, and Schwab. (Source: Wikipedia)

Hedge Fund

What is a hedge fund?

A hedge fund is a private investment fund or pool that trades and invests in various assets such as securities, commodities, currency, and derivatives on behalf of its clients, typically wealthy individuals. (Source: CFTC)

Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.

Unlike mutual funds, however, hedge funds are not required to register with the SEC. Hedge funds typically issue securities in “private offerings” that are not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make period reports under the Securities Exchange Act of 1934. But hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.

What are "funds of hedge funds?"

A fund of hedge funds is an investment company that invests in hedge funds -- rather than investing in individual securities. Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.

Before investing in a hedge fund or a fund of hedge funds, be sure to:

1. Read the fund's prospectus or offering memorandum and related materials. Make sure you understand the level of risk involved in the fund's investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.

2. Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources.

3. Ask questions about fees. Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds.

4. If you invest in hedge funds through a fund of hedge funds, you will pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.

5. Understand any limitations on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year), and often impose a "lock-up" period of one year or more, during which you cannot cash in your shares.

6. Research the backgrounds of hedge fund managers. Know with whom you are investing. Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the NASD's BrokerCheck database for any information they may have.

7. Don't be afraid to ask questions. You are entrusting your money to someone else. You should know where your money is going, who is managing it, how it is being invested, how you can get it back, what protections are placed on your investment and what your rights are as an investor. In addition, you may wish to read NASD’s investor alert, which describes some of the high costs and risks of investing in funds of hedge funds. (Source: SEC)

A hedge fund is a private investment fund charging a performance fee and typically open to only a limited number of investors. Hedge Funds have grown in size and influence on the public securities and private investment markets. Hedge Funds are not currently subject to any direct regulation, unlike mutual funds, pension funds, and insurance companies.

The term is not tightly defined, but is used to distinguish such funds from retail investment funds that are available to the general public. An example of such retail funds in the US are Mutual Funds. Retail funds tend to be highly regulated, limited to holding -- being long of -- a specific range of financial assets such as bonds, equities or money market instruments. Retail funds tend to have a restricted ability to borrow, leverage or hedge their investments, though they may have a limited ability to hedge via derivative contracts.

Hedge funds are limited only by the terms of the contracts governing the particular fund. Hedge funds may be either long or short assets and may enter into futures, swaps and other derivative contracts. In this way, hedge funds are able to follow more complex investment strategies intended to profit from market volatility or from falling market.

Because of the substantial risks involved in unregulated, complex and leveraged investments, hedge funds are normally open only to professional, institutional or otherwise accredited investors. This restriction is often implemented though limits on investor numbers or minimum investment amounts. (Source: Wikipedia)

See also:
Hedging
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