Bozena Pomponio, BridgeTower Media Newswires
Exchange-traded funds (ETFs) have become a globally significant investment vehicle in the last 26 years. SPY, or the SPDR S&P 500 ETF Trust, was the first U.S. ETF launched on Jan. 29, 1993 by State Street. Currently, (through February 2019) ETFs are a $3.71 trillion industry, up from $65.6 billion in 2000 (Source: Investment Company Institute).
ETFs can be formed in one of five ways: open-end funds, unit investment trusts, grantor trusts, exchange traded notes or as a partnership. Each of these particular structures has specific tax or other advantages/disadvantages. One primary differentiator is that those formed as open-end funds or unit investment trusts afford their investors protections codified in the Investment Company Act of 1940 (the 1940 Act), whereas the other three do not.
As for the more traditional forms of ETFs, shares of these particular funds trade intraday on stock exchanges at prices determined by the market. They can track either traditional indices, such as the S&P 500 and Dow Jones Industrial average, or — more recently — relatively obscure benchmarks such as global clean energy. Traditional ETFs are managed to mirror the holdings and performance of a particular index.
Furthermore, ETFs are attractive to investors because they exhibit low costs, transparency and tax efficiency. They track underlying indices and don’t change their holdings frequently, making them relatively cheap compared to actively managed mutual funds.
There are also other reasons why some investors prefer ETFs over mutual funds. ETFs may be traded intraday at current market prices where mutual funds use end-of-day prices. Certain data has also shown that indexing (or passive investing) may provide more consistent returns for some investors when compared to actively managed open-end mutual funds. Including ETFs in your trading strategy can help hedge risk, increase market exposure and diversify your portfolio.
As mentioned previously, another variation of the ETF is known as an exchange-traded note (ETN). ETNs are assets issued by a major bank as senior debt notes. This differs from an ETF, which actually holds securities, commodities or derivatives such as futures, options and forward contracts. ETNs are subject to the Securities Act of 1933 and the Securities Exchange Act of 1934, but are not regulated by the 1940 Act.
In addition, ETNs can be bought and sold throughout any trading day, just like ETFs. There are currently many more ETFs in the investing world than ETNs. As of the end of March 2019, there were 2,248 ETFs and 162 ETNs.
When you buy an ETN, you buy a debt asset similar to a bond, but the terms of the debt contract are determined by the structure of the note. ETNs are backed by a bank with a high credit rating, so they are pretty secure products. However, ETNs are not without credit risk. The main difference between ETFs and ETNs is that ETFs are only subject to market risk where ETNs are subject to both market risk and the risk of default by the issuing institution.
Comparing ETFs and ETNs will reveal many similarities. For example, both ETFs and ETNs track commodity, currency, and equity market indices. Also, ETNs are bought and sold with a traditional brokerage account just like ETFs. However, there are also some differences. ETNs have maturity dates, unlike ETFs. Moreover, ETNs eliminate tracking error relative to their benchmarks.
ETFs also could be compared to closed-end funds, which have some similar characteristics. Both contain baskets of securities and trade intraday in the open market; however, some important distinctions exist that may make investing in closed-end funds more attractive. Closed-end funds are actively managed, while most ETFs track an index. Further, CEFs issue a fixed number of shares traded in the open market at a premium or discount to the NAV. When closed-end funds trade at a substantial discount to NAV, they have the potential to outperform ETFs as that discount is reduced.
Unlike closed-end fund shares, market specialists and institutions tend to keep ETF shares as close to the NAVs as possible. It is rare to see ETFs trading at a large premium or discount to their NAV. A closed-end fund’s discount provides investors with a cushion against future declines in the fund’s NAV.
In conclusion, it is important to know what exactly you are investing in when you purchase a security. Whether it is an ETF, ETN, closed-end fund or another investment vehicle, make sure you do your homework before diving in. If you feel uncomfortable making these types of decisions on your own, it may be best to consult an investment professional.
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Bozena Pomponio is an Analyst/Portfolio Manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534, (585) 586-4680.
