• Exchange-Traded Funds
  • ETFs and ETNs: Knowing What You Own

    by Neil Leeson

    One of Warren Buffett’s famous quotes that many investors and portfolio managers follow and recite to their followers, “never invest in a business you can’t understand,” can be applied to investing in exchange-traded products (ETPs).

    The nomenclature ETP is rarely used in the popular press or by investors; even Ned Davis Research has an ETF Service. All ETPs are not created equal. There are exchange-traded funds (ETFs), exchange-traded notes (ETNs) and unit investment trusts (UITs). Many will add open- and closed-end mutual funds to the ETP basket as well. To confuse matters more, many of these vehicles have different structures: grantor trusts, limited partnerships and open-ended 1940 Investment Company Act funds. These are all important considerations when determining the tax implications, tracking error, asset allocation and distribution differences in owning a fund.

    To delve into the differences of structures would take much more space than allotted for this article, but I will cover the three main investment companies. Nearly every ETP provider has literature on their website explaining the differences and similarities among products. In addition, there has been a plethora of books, articles and academic literature published on the subject. For the purpose of this article I want to focus on ETFs and ETNs, explaining the basic mechanics of how they trade, and why it is important to know what you own.

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    Neil Leeson is research director at Spyglass Trading LP.


    Discussion

    Arnie Zimmer from VA posted over 3 years ago:

    Since I am a novice investor, I invest in index mutual funds that have a low expense ratio. ETP's appear to have the additional expense of dealing with the spread between the bid and asked prices. How much does the spread add to the expense ratio? Is there any way to get a handle on which ETP's or family of ETP's have the narrowest spreads? Do ETP's with a higher NAV have a narrower percentage spread than products with a lower NAV or is liquidity the predominant factor? Are inverse ETP's just for short-term use? I can only see bond yields going higher. I am tempted to invest in an inverse long term bond fund for an extended period of time.


    Earl Lash from CO posted over 3 years ago:

    WHEN ETF money inflow INCREASES in an up surge market DO THE ETF'S buy high with incoming money and sell low when ETF'S are sold on a declining market?


    Earl Lash from CO posted over 3 years ago:

    WHEN ETF money inflow INCREASES in an up surge market DO THE ETF'S buy high with incoming money and sell low when ETF'S are sold on a declining market?


    Robert Brown from MD posted over 3 years ago:

    IS THE SHADOW FUND AVAILABLE IN AN ETF ?


    Tom O'Brien from IL posted over 3 years ago:

    THERE IS NO DISCUSSION IF THERE ARE NO ANSWERS TO THESE INTERESTING QUESTIONS

    IS THERE ANY CHANCE AAII COULD RESPOND TO THESE QUESTIONS ON AN ONGOING BASIS?

    DO YOU EVER ANSWER THESE QUESTIONS??


    Charles Rotblut from IL posted over 3 years ago:

    Arnie - The bid and spread are transaction costs. You only pay them when you buy or sell a security. Management and other fees, which are measured by the expense ratio, are paid every year you own the fund. I would be far more concerned with picking the best fund for the asset class that you are trying to target than trying to seek the narrowest bid/ask spread.

    As far as inverse ETPs, read the prospectus. Many only give you the opposite return for a single day. After one day, the ETF's return starts to be detached from that of the underlying security.

    Earl - It depends on whether institutional investors are asking for more creation units. See Neil's discussion of creation and redemption above.

    Robert - There is no fund that tracks the Model Shadow Stock Portfolio.

    -Charles


    Warren Laird from KY posted over 3 years ago:

    I agree with Tom O'Brien. Why a discussion period with no response?


    Chintan Bhatt from PA posted over 3 years ago:

    Just as Vanguard is probably the best place for passive index investing with low expense ratios for mutual fund, waht would be recommendation for ETF purchase, hold, and sell?

    For exampple, if I am interested in purchasing XLF or XHB at current prices, can I / should I go through my current brokerage and purchase or is there an organization like Vanguard for ETPs that is ideal for an individual investor?

    Thank you.


    Charles Rotblut from IL posted over 3 years ago:

    Hi Chintan,

    The commissions you will pay for buying an ETF vary from broker to broker, but typically range in the $7 to $10 per trade range. Some brokerage firms have a specific set of ETFs that you can be commission-free (Fidelity, TD Ameritrade, etc.)

    Our annual Discount Broker Survey shows which firms your fellow AAII members use and like. You can see a comparison of the most popular firms at:
    http://www.aaii.com/brokersurvey/YearEnd_Top10

    -Charles


    Chintan Bhatt from PA posted over 3 years ago:

    Thank you.


    Cliff Rafter from FL posted over 3 years ago:

    An excellent primer on etfs.

    Thx.


    Charles Waldrop from TX posted over 2 years ago:

    Excellent article but also some excellent questions that would really be nice if answered.


    Ed Blansten from New York posted about 1 year ago:

    I attended a conference on this very topic - the ETP Forum NYC - it was excellent and not your usual event - very sophisticated and great Portfolio Managers as speakers - all info was here www.expertseries.org


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