How regulatory changes could lead to a boom in new ETFs, including actively managed ETFs. Why ETFs continue to be one of the most innovative, cost-effective and tax-efficient investment vehicles.
“Exchange-traded products are among the most significant financial innovations in recent decades and have shaped financial markets as we know them today,” said Michael S. Piwowar, former Commissioner of the U.S. Securities and Exchange Commission.
The growth in exchange-traded products (ETPs) has been incredible over the past decade. There is $4 trillion invested in U.S. sponsored exchange-traded products (ETPs), spread across 2,435 different funds. That is up from $794 billion invested in ETPs in 2009. The overwhelming majority of those assets are invested in exchange-traded funds (ETFs) as there is only about $20 billion in exchange-traded-notes (ETNs).
Despite the growth in ETFs, mutual funds still have a commanding lead with 8,000 U.S. sponsored mutual funds managing over $15 trillion in assets. Yet mutual funds continue to lose market share to ETFs. So far in 2019, $135 billion has flowed into ETFs while mutual funds have experienced $200 billion in outflows.
ETF Advantages
ETFs have several advantages over mutual funds. Their expenses are lower, and they are more tax efficient. This is due to the unique process ETFs have for creating and redeeming new shares. Rather than handling the share creation and redemption process internally like mutual funds, ETFs work with outside institutional traders called authorized participants to create and redeem new shares.
In addition, most ETFs trades occur on stock exchanges rather than directly with the sponsor, which means the ETF sponsors incur lower costs related to shareholder services compared with mutual funds. This intraday trading also results in greater liquidity for ETFs relative to mutual funds, which only trade at the end of the day. For most long-term investors this ability to trade during the day isn’t particularly meaningful.
One concern with ETFs is that while they appear to be quite liquid, the ETFs’ underlying holdings might be illiquid during times of financial stress. For example, an ETF that invests in bank loans or high yield bonds might find authorized participants are unwilling to participate in the share redemption process if the authorized participants don’t believe they will easily be able to sell the holdings they are given in exchange for ETF shares.
Actively Managed, Non-transparent ETFs
Recently, the U.S. Security and Exchange Commission made two regulatory changes that will make it easier for mutual fund companies to compete with ETFs.
The SEC approved a framework that will allow for actively managed ETFs. Previously ETFs had to frequently disclose their holdings in order to facilitate share redemption and creation. Now the SEC will allow non-transparent ETFs. This is a special class of ETFs in which the sponsor doesn’t have to make its holding publicly available on a daily basis. Instead, the ETF sponsor will work with special representatives who get to see the holdings and promise not to disclose them. Those representatives in turn will work with authorized participants to facilitate ETF share redemption and creation.
Active managers don’t like to disclose their holdings on a daily basis as it can tip off competitors and traders as to what they are buying or selling, potentially making it more costly to enter or exit the underlying holdings.
Easier to Launch New ETFs
Another change is the SEC has made it easier for ETF sponsors to launch new ETFs. Previously, each ETF had to be closely vetted by the SEC before given permission to launch. Now ETF sponsors can follow certain rules and steps to launch an ETF without having to get direct approval by the SEC.
These two changes will more than likely lead to an increased supply of ETFs as sponsors will be able to launch new products at a lower cost and will have more flexibility to launch actively managed ETFs.
Of course, more ETF products doesn’t necessarily mean better investment options for individual investors. It could just mean more expensive ETFs that underperform passive indices in the same way that many actively managed mutual funds do.
To learn more about how changes in the ETF landscape can impact you as investor, please listen to this episode of the Money For the Rest of Us podcast.
Topics covered in the episode include:
- How big is the ETF market relative to mutual funds.
- What are the benefits of ETFs that have allowed them to gain market share from mutual funds.
- What are some of the negatives with ETFs.
- What has changed to make it easier for sponsors to launch new ETFs.
- How do non-transparent actively managed ETFs work.
- What are some examples of more complicated, outcome-based ETFs.
Show Notes
Why Are ETFs So Cheap?—ETF.com
Washington Gives Exchange-Traded Funds Fast Lane to Market by Dave Michaels—The Wall Street Journal
‘Non-transparent’ ETFs set to be a boon for fund managers by Richard Henderson—Financial Times
Non-transparent ETFs lure asset managers by Emile Hallez—Financial Times
New Series of Cboe S&P 500 Target Outcome Indexes White Paper
Episode 240 Plus – Part 1 on the Innovator S&P 500 Buffer ETF
Episode 246 Plus – Part 2 on the Innovator S&P 500 Buffer ETF
Cboe S&P 500 Dividend Aristocrats Target Income Index – Monthly Series
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Episode Chronology
- [2:45] The benefits of ETFs
- [8:40] Challenges with ETFs
- [12:50] The rules that have changed
- [15:25] What is an AP Representative?
- [18:40] Should you invest in actively managed ETFs?
- [21:30] All about outcome Based ETFs
- [26:20] Understand what drives performance
Related Content
58: Are ETFs and Indexing Becoming Too Popular?
247: More Indexes, ETFs and Manager Skill, but Less Alpha
273: What is an ETN? Understanding Exchange-Traded Notes
321: How to Analyze Complex Investments
Transcript
Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 277. It’s titled Why ETFs Are Changing.
How big are exchange-traded products?
A few episodes ago, episode 273, I mentioned in the US there are over $4 trillion invested in US-sponsored exchange-traded products. That includes about 2,300 exchange-traded funds and another 165 or so exchange-traded notes. That compares to only $794 billion in 2009 in exchange-traded products. Now, ETFs and ETNs are much smaller compared to mutual funds. In the US there are more than 8,000 mutual funds with $15.4 trillion in assets. About 25% is invested in passive index funds.
Now, while the mutual fund industry is bigger, it has been losing ground to ETFs. In 2019 there’s been more than $135 billion in inflows into ETFs and $200 billion pulling out of mutual funds. Given how ETF’s market share is growing and has been growing, as investors, we need to understand what is happening in the ETF space, and recognizing mutual funds are not just going to stand by, particularly actively managed mutual funds, and let their market share diminish.
ETFs are growing
So this episode we’re looking at what is changing with ETFs. Why it’s easier for companies to create ETFs, why they’re creating actively managed ETFs, and we’re going to look at some examples of some new ETFs products are somewhat intriguing.
One of the interesting things with ETFs, it’s a very concentrated industry. According to a report by CFRA, “ETF assets grew by over 90% for the five years ending August 2019, but just 100 funds captured 83% of those assets, and BlackRock and Vanguard managed two-thirds of those funds”. Vanguard and BlackRock, which owns the iShares brand, they are the biggest players, and then you have these smaller players around that that are launching more and more ETFs.
What are the benefits of ETFs that have allowed their market share to grow at the expense of mutual funds? Well, first, lower fees. The expense ratios on ETFs are lower than mutual funds across the board, and that’s not just because ETFs are primarily passive. If we look at index mutual funds compared to passive ETFs, ETFs still have lower expense ratios because it’s less expensive for a fund sponsor to operate an ETF.
This was a paragraph from etf.com. Here’s what they said. “When a mutual fund receives a buy order from a new investor, it has a lot of work to do. First, it must process the order internally, recording who it was that entered the buy order and how much money was deposited with the firm. The fund company must then send out confirmation documents and handle any compliance issues, then the mutual fund’s portfolio manager must go into the market and invest the money, buying and selling securities and paying all the necessary spreads and commissions involved.”
Now, that particular paragraph was a few years old, but there is more shareholder services related to mutual funds versus ETFs because most ETF trades are done in the secondary market with a seller of the ETF selling it to somebody that wants to buy the ETF.
ETFs are tax-efficient
Another benefit of ETFs is that they’re just more tax-efficient. To better understand why ETFs are more tax-efficient, we have to review how ETFs trade and how they differ from open-end mutual funds. A mutual fund trades at the end of the day. Investors that want to buy into the fund, investors that want to exit the fund, they exit at the fund’s net asset value, and then the fund’s sponsor, if there’s net inflows, will create new shares of that mutual fund. ETFs, as I mentioned, they trade in the secondary market. Individuals that wanted to buy an ETF, they’ll go to their broker and they’ll put in the trade, and that trade is matched with somebody that wanted to sell the particular ETF, but there are what are known as authorized participants, big institutional players that interact directly with the ETF sponsor.
The authorized participant can exchange what’s known as the creation basket. It’s a reference basket of securities that represent what is owned by the exchange-traded fund. The authorized participant trades that creation basket for new shares of the ETF. Also, the authorized participant can trade shares of the ETF for the holdings that are in that creation basket. Now, these are generally very, very large trades. That process of the ETF sponsor interacting with the authorized participant leads to the creation and redemption of ETF shares.
Now, here’s the key. The ETF sponsor can choose what goes in that creation basket, and if an authorized participant wants to redeem shares, they give those ETF shares to the sponsor, and then the sponsor can put low-cost basis stock in that creation basket. A low-cost basis stock is a security that has appreciated a great deal in price, and if it was sold, would trigger a large capital gain, but by transferring those low-cost basis securities as part of the share redemption process, the ETF sponsor doesn’t have to pass that capital gains to the holders of the ETF. And then the ETF owners don’t have to pay taxes. With a mutual fund, the mutual fund has to actually sell the holdings. If there’s redemptions, they’re selling the underlying holdings triggering a capital gain that then has to be passed on to the shareholders who pay the capital gains tax. Consequently, ETFs are just more tax-efficient.
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