On Your Mind: Latest Questions on Exchange-Traded Funds

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On ETFs

On Your Mind: Latest Questions on Exchange-Traded Funds
Michael Iachini
CFA, CFP®, Director, Investment Manager Research, Charles Schwab Investment Advisory
July 22, 2010

I was on the road recently talking to clients about exchange-traded funds, better known as ETFs, and received many great questions. Some people asked about the basics, while others wanted to know about highly technical details. This month, instead of a deep dive into a particular ETF topic, I've collected the questions that were most often on clients' minds, and provided answers.

Have an ETF question of your own? We'd like to hear from you, and we may use your question in a future article—just send it to us via the Editor Feedback box on the right.

How is a SPDR or an iShare different from an ETF?
SPDRs and iShares are simply two "brand names" of ETFs managed by different companies. SPDRs (pronounced "spiders") are the brand name State Street Global Advisors gives to the ETFs it manages, which include the well-known S&P 500 SPDR (SPY), the original US ETF. iShares are the ETFs managed by BlackRock (formerly by Barclays Global Advisors). Other ETF brands include PowerShares, Currency Shares, Vanguard ETFs and Schwab ETFs, among others. So SPDRs and iShares are ETFs, just from particular companies.

Are there companies that manage both mutual funds and ETFs?
Yes. In fact, this is the norm rather than the exception. The biggest ETF providers by assets—State Street Global Advisors (SPDRs), BlackRock (iShares) and Vanguard—all manage mutual funds as well, as does Schwab. Many companies with mutual fund expertise have introduced their own ETFs since they already possess much of the know-how required to manage exchange-traded funds.

Which is cheaper, an index mutual fund or an ETF?
We can look at this in three ways.

Usually this question is about a fund's operating expense ratio, which affects a fund's returns a little bit each day. The expense ratio is the percentage of the fund's assets deducted each fiscal year to cover management, administrative and advertising fees and other operating expenses. ETFs typically have the lower expense ratios, but the lowest-cost index mutual funds tend to have expense ratios that are right in line with ETFs.

You should also think about transaction costs when choosing an ETF or index mutual fund (or any investment for that matter). Index mutual funds are often available with no load and no transaction fee. With ETFs you'll typically pay a commission every time you buy or sell shares, though at some brokerages certain ETFs are available commission-free.

Finally, it's worth considering minimum investments. You can purchase just a few shares of an ETF if you like, but some index mutual funds require substantial minimum investments—often $2,500 but sometimes as high as $100,000—in order to purchase the lowest-cost shares.

Do ETFs use derivatives?
Some do, yes. A derivative is a financial instrument whose value is tied to, or "derived" from, the value of some other security. For instance, a futures contract to deliver a certain amount of oil at a certain price on a certain date is a derivative of the price of oil.

Plain-vanilla stock and bond ETFs seldom use derivatives. Derivatives are more common among commodity ETFs, currency ETF, and leveraged or inverse ETFs. For instance, these ETFs may use futures contracts tied to the price of an index to put excess cash to work. Futures contracts are cleared through a clearinghouse, which helps to mitigate counterparty risk—the risk that the company that sold the contract (the counterparty) will not be able to hold up its end of the bargain.

Some ETFs (generally the more exotic leveraged and inverse funds) use swap contracts, which do not trade via a clearinghouse and therefore have more counterparty risk.

What is an ETN? How is it different from an ETF?
ETN stands for exchange-traded note, and it's essentially a bond, not a mutual fund like an ETF. With an ETN, the company that issues the note promises to pay investors the cumulative return of some index over some time period (such as 10 years). If you buy the note when it's issued for $10 and the index doubles in value over the next 10 years, the company promises to pay you $20 at the end of that period (minus expenses).

The good news with an ETN is that there is theoretically no tracking error—the return on the ETN is promised to tie directly to the return on the underlying index. The bad news is credit risk—the ETN is only as good as the company that stands behind it. This makes ETNs riskier than ETFs in an important way. Which leads us to ...

What would happen if the company that managed my ETF went out of business? Would my ETF become worthless?
Your ETF would not become worthless. An ETF is legally a separate entity from the company that manages it. Most ETFs are structured as standalone investment companies and have their own boards of directors (the few ETFs not structured as investment companies have similar functions in place).

The company that manages an ETF is essentially employed by the ETF itself, hired to manage the assets. If that managing company ceases to exist, the ETF's board of directors would be responsible for hiring a new investment manager and the ETF would carry on as before. From an investor's point of view, it would look as if the ETF were acquired by another firm.

In the unusual case where the ETF board did not hire a new manager, the ETF's assets would be unmanaged and eventually liquidated. Shareholders would then receive their portion of the value of the ETF's holdings.

Note that this is very different from an ETN, which, as mentioned above, is just a bond issued by the managing company. If the company that issued the ETN goes out of business (as happened with Lehman Brothers and its three ETNs in 2008), the ETN becomes a nearly worthless piece of paper. Holders of the ETN become creditors of the failed company, standing in line with everyone else in the hopes of getting some of what they are owed.

How are ETF shares created and redeemed?
ETF shares are created and redeemed between the ETF company and certain large investors called Authorized Participants (APs). Let's look at how this works with a stock ETF.

Creation starts with an AP identifying a reason to create new ETF shares. For instance, the ETF's price may be a little bit higher than the value per share of the stocks it holds (called the fund's net asset value, or NAV). The AP can buy shares of the underlying stocks and deliver them to the ETF company. The ETF company takes those stocks and in exchange issues new shares of the ETF to the AP (usually 50,000 or 100,000 ETF shares at a time). The AP can then sell those new ETF shares on the market at the price that was slightly above the price per share of buying the underlying stocks. In this way, the AP makes a small arbitrage profit, and the new supply of ETF shares on the market helps push the price of the ETF back down toward the underlying value of the stocks in the portfolio (its NAV).

Redemption follows the same process in reverse. Let's say that ETF shares are trading at a price a little below the fund's NAV. In this case, the AP can buy shares of the ETF and deliver them to the ETF company. The ETF company will retire those shares and give the AP the shares of the underlying stocks in the portfolio, which the AP can then sell for a small profit. In this way, the AP again makes a small arbitrage profit, and by removing some ETF shares from the market it helps push the ETF's price up toward its NAV.

Note that this process works best when the underlying stocks (or bonds in the case of a bond ETF) are easy and cheap for APs to trade. This is why you may see ETFs trading at prices above or below their NAVs when the underlying stock or bond markets become illiquid, as the bond market did during the credit crisis of 2008.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Diversification does not eliminate the risk of investment losses.

Due to the limited focus and special risks of currency and commodity funds, they may experience greater volatility than funds with a broader investment strategy.

Most leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives and options can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily.

Charles Schwab Investment Advisory, Inc., is an affiliate of Charles Schwab & Co., Inc.

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