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ETFs Part 4: What’s inside an ETF?

Learn about what you actually own when you own an ETF as well as why tracking may vary

Unlike mutual funds, most ETFs are required to disclose their holdings every day. For example, you know when trading the Schwab US Large-Cap ETF (SCHX) that it is tracking the performance, before fees and expenses, of the Dow Jones U.S. Large-Cap Total Stock Market Index. By buying shares of SCHX, you gain exposure to a portfolio comprised of approximately 750 U.S. large-cap stocks. Other types of ETFs may hold bonds, foreign currencies, precious metals, futures contracts, derivatives (exchange-traded or over-the-counter), or some combination of these assets.

With the expectation that the ETF essentially owns all of the same securities the index lists, ETF investors sometimes wonder why the returns on a particular ETF do not exactly match the returns of an ETF’s specified index (although they are usually very close). There are a number of factors that contribute to ETF tracking error: 

  1. Sampling – Some ETFs may not hold all of the securities specified by the underlying index (especially in less liquid asset classes). Instead, the ETF may hold only a subset of securities the manager believes have a high probability of providing the same pattern of returns as the index. If the manager’s sample is not reflective of the entire index, the returns on the ETF will differ from those of the index.
  2. Expense ratio – The indexes tracked by ETFs do not account for fees collected by ETF sponsors. These fees are deducted from an ETF’s NAV each day. At the end of any 1 year period (all else being equal), an ETF’s return should be equal to that of the index minus the expense ratio.
  3. Dividend reinvestment – Depending on the fund’s legal structure, ETFs may be allowed to reinvest dividend payments received from the underlying stocks in their portfolios. There can be a slight delay between when the dividend is received and how quickly it can be re-invested, which may or may not be accounted for by the ETF’s index. Furthermore, ETFs structured as unit investment trusts are not allowed to reinvest dividends at all, creating a bigger cash drag on performance. 
  4. Taxes – Some types of securities (notably MLPs) are not allowed to be held in an ETF that uses the normal “pass through” tax structure. As a result, ETFs holding MLPs are required to be taxed as C-corporations. This means these funds must withhold and pay corporate income taxes, which are generally not accounted for in the indexes they track. 
  5. Securities lending – Not all tracking errors are bad! Sometimes an ETF can outperform its index. One way these can happen is through securities lending. Since ETFs typically have portfolios with low turnover, ETF managers can earn extra income by lending the shares in the portfolio to other market participants who may want them for short-selling, facilitating settlements or even assisting in the creation/redemption of other ETF shares. 

So you now know what you own when you buy an ETF, but we still haven’t covered what may be the most important aspect. Continue on to the next article of this series to discover 5 Reasons Traders Like ETFs.

Know When to Roll ‘Em: How to Roll Options Positions
Know When to Roll ‘Em: How to Roll Options Positions
ETFs Part 2: The Evolution of ETFs

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Important Disclosures

Investors should consider carefully information contained in the prospectus, or, if available, the summary prospectus including investment objectives, risks, charges, and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing. Past performance does not guarantee future performance.


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