The Public Interface

This essay was written in December, 2015. Market data, product details, fees, and regulatory information reflect that period.

There are countless investment vehicles investors can use to grow their portfolios. Some investment tools are notable for diversification. Other investments are attractive for their low fees. Imagine an investment tool that maximizes control and diversification, minimizes fees, and requires minimal effort. That’s an Exchange Traded Fund. ETFs are collections of securities that can be traded like stocks. They are backed by pools of assets that are selected to track industries or indexes (Kosev 51). When evaluating ETFs compared to other investment vehicles based on return, risk, and personal management effort, ETFs generally have average return, low risk, and low effort. Exchange Traded Funds are powerful investment vehicles that enable average and inexperienced investors to maximize their return on investment.

The desire for index tracking tools started to increase as more investors realized that buying an index could outperform many other investment strategies. The first ETF was made as an index tracking tool, it went public to trade on January 1, 1993. This was the SPDR S&P 500 ETF ($SPY). $SPY was designed to simply track the S&P 500. This was and still is the main purpose of ETFs. Right now, $SPY is the most widely held fund in the world with total assets worth more than $181 billion and average trading volumes reaching over 120 million per day (TD Ameritrade). Now there are ETFs that track most any index one can think of including stocks, REITs, bonds, and commodities (Simpson). ETFs have proven to be successful trackers of indexes and industries, making them effective investment tools.

ETFs are a great tool to utilize in a retirement portfolio. It is important to start saving for retirement early in life. The power of compound interest is astounding when starting to make a retirement plan. Figure 1 demonstrates the power of compound interest, the difference is demonstrated by Susan and Bill. Susan invests $100,000 less than Bill, but invests from ages 25-35 instead of from 35-65. Susan ends up with $57,000 more at age 65 simply because she invested early. This is the power of compound interest. Many people do not know where to start investing and end up putting it off until later in life, this is extremely detrimental to total amount the investor will have at the age of retirement. ETFs are the perfect place for investors to start growing their retirement accounts. Chris from Figure 1 has great investment habits. He invests a total of $200,000 from the ages 25 to 65 and ends up with over a million dollars in his account by the time of retirement.

Furthermore, the U.S. Department of Labor defined benefit plans from employers are significantly decreasing over the past 30 years. Over the same period, defined contribution plans have risen, as shown in Figure 2. These trends make personal investment more important to many more people as the luxury of the defined benefit plan dwindles. Personal investment also becomes more important as workers are changing employers much more frequently than previous generations. A summary of an Executive Roundtable at the University of Southern California evaluates the millennial generation: “This generation is tech savvy and focused on personal fulfillment. They are less loyal, changing jobs more frequently than previous generations.” (SHRM). This impacts retirement plans because workers will be more inclined to use defined contribution plans so they can take their savings with them as they transfer jobs. ETFs are an important tool to empower these defined contribution plans as the plans become commonplace in the workforce.

ETFs are unique in their diversification in that one can buy a single share that can potentially give you stake in several types of investments. Having this diversity is key to a strong investment portfolio. Mitch Kosev, economist at the Reserve Bank of Australia, defines ETFs as: “…securities backed by a pool of assets, the return on which is expected to track a specific benchmark as closely as possible.” (Kosev 51). ETFs are not only backed by individual stocks, but also by many different types of assets including stocks, bonds, commodities, and real estate. For example, one ETF could have one third of its portfolio in Apple Inc., one third in government bonds, and one third in Public Storage Real Estate Investment Trust (REIT). So, this ETF would have the diversity of three different types of investments that can be acquired through one single trade. Because of the volatility in various types of investments and individual securities, investors want to their portfolios to be diverse to minimize risk and volatility. ETFs become an attractive option for investors due to their diverse underlying securities.

Pricing ETFs is unique when compared to other investment options; ETFs act as a hybrid between stocks and mutual funds. This pricing scheme let ETFs reap some of the benefits from both stocks and mutual funds. An ETF’s net asset value (net asset value is the sum of all a fund’s assets minus liabilities, divided by the number of shares outstanding) is calculated at the end of each trading day. These net asset values embody the value of the underlying shares of the funds. When an ETF’s net asset value is $10.00 and the shares are trading at $10.10 it means that the shares are trading at a 1% premium, if shares were trading at $9.90 this would be a 1% discount to their net asset value (Wilmington). This pricing process is important to note because ETFs are still funds, but provide many of the trading advantages of stocks because they are traded on the open market.

Much like a stock, some ETFs provide dividends to investors. ETF dividends are a proportionate collection of the dividends of the underlying shares. There are two common ways that ETF providers use dividends. The first is keeping all the dividends in cash and paying them on the dividend date respectively. SPDR S&P 500 ETF $SPY employs this method, $SPY schedules quarterly dividends and pays out all the cash that it holds from the dividends it receives from the underlying shares. The second method is to reinvest the dividends in the same stocks as the index until the payment date. This leverages the ETF because in a sense, this money is borrowed from the investors. A comparison ETF to $SPY that employs this method is iShares Core S&P 500 ETF $IVV, $IVV also tracks the S&P500. $IVV does slightly better than $SPY in bull markets because the extra gains from the reinvested dividends. But the opposite is true in a bear market, the reinvested dividends end up in a greater loss. Either way the same dividend is paid out to the investor, but the value of the ETF is impacted based on the positive or negative returns of the reinvested dividends (Cummans). ETFs leave the investor with the option of reinvesting their dividends after the payment date or using them as cash.

The structure and creation of ETFs can provide many different benefits to investors. ETFs are created through what is called the “creation/redemption” mechanism. The process starts when an ETF provider teams up with an authorized participant (AP)—organizations with a lot of cash, usually banks such as Goldman Sachs or Morgan Stanley. Many APs can back a single ETF, most of the time there actually are multiple APs for a single ETF. The AP buys shares of stock from the open market in the correct proportion to the ETF that will be created, and then trades them with the ETF provider in exchange for a “creation unit” or block of usually 50,000 ETF shares. This exchange is made on the net asset value price not the current share price. The AP can then sell these ETF shares on the market for a profit. ETF shares can be removed from the market by the AP purchasing enough of the ETF shares from the market to form another block and then exchanging them with the ETF provider for the equivalent value in the shares that back the ETF (JP Morgan) (ETF.com). All the market trades by the AP are to other investors. Most trades on the market are kept blind to the public. The exception is when the investor holds more than 10% of the company or when the investor is a director or officer in the company. These trades can be viewed through the Securities and Exchange Commission by the public (Krantz). This information is available because these people know what is going on inside the company, their moves must be public to help level the playing field between the employees and outside investors. So investors do not know who they are purchasing securities, or ETF shares from when they are trading with the AP. They would only be able to see which AP is buying or selling the ETF at the time if the AP is a 10% shareholder.

Figure 3 demonstrates the creation/redemption process of the exchange between ETF shares, underlying shares, and cash. The underlying shares are what give value to the ETF shares; the ETF shares represent the total collection of underlying shares. By simply buying an ETF share on the stock exchange, the investor can easily access this unique collection of underlying securities that was designed by the ETF provider.

For ETFs, the creation/redemption process guides the ETF share price to stay equivalent to their net asset value, while maintaining efficiency. When the underlying securities net asset value of an ETF is priced at a discount to the ETF share price, the AP goes through the creation/redemption process and buys the underlying shares driving their price up, and creating more ETF shares, driving the ETF price down. When the underlying securities net asset value is at a premium to the ETF share price, the AP purchases ETF shares driving their price up, exchanges them with the ETF provider for the underlying shares, then sells the underlying shares driving their price down (JP Morgan) (ETF.com). This balancing act is extremely efficient and keeps the share price in line with the ETF’s net asset value. This is important because investors do not want to pay more than the ETF is actually worth. The indicative net asset value (IV) is an approximate measure of the net asset value that investors can use to help guide their trading decisions throughout the day (Wilmington). The unique construction of ETFs allows the price to stay closely aligned with the net asset value in an efficient manner.

The creation/redemption process provides ETFs with an advantage over closed ended funds. Closed ended funds do not permit an AP to create and redeem shares throughout the day. This leaves the closed ended fund price often far away from the fund’s net asset value, while ETF prices generally stay closely aligned thanks to the AP’s monitoring of the ETF share price (Proshares 4). This is beneficial to the investor because they will pay a closer price to the real value of the fund. Investors should know what they are buying and hopefully pay a fair price that has not been swayed far away from the net asset value during the day by supply and demand.…