The Exchange-Traded Funds Manual, 2nd Edition

Preface ix

Acknowledgments xi

Chapter 1 An Introduction to Exchange-Traded Funds 1

Exchange-Traded Funds Were Introduced as “Something to Trade” 1

Shareholder Protection 3

Tax Efficiency 7

Cost Transparency is Desirable, But Trading Transparency is Costly 9

Intraday ETF Trading 10

Comparing ETF and Mutual Fund Economics 11

Conclusion 17

Chapter 2 The History and Structure of Exchange-Traded Funds—and Some of Their Competitors 19

Some Major Financial Market Developments (1975 to 2000) 19

Declining Trading Costs Increase Financial Engineering Opportunities, and Financial Engineering Reduces Trading Costs in the New Millennium 23

A Brief History of ETFs 25

Other Tradable Basket Products 34

Chapter 3 The Regulatory Framework and Mechanics of the Open-End ETF 43

U.S. Fund Regulation Has Played a Major Role in the Structure of ETFs Introduced around the World 43

The Investment Company Act of 1940 45

Exemptions from the Investment Company Act of 1940

Have Been Granted to Permit Issuance of Open-End ETFs 47

ETF Developments Outside North America 50

Proposed Rule 33-8901 and Limitations on ETF

Trading Transparency 53

The Mechanics of ETF Creation and Redemption In-Kind 53

Chapter 4 Taxation of ETFs and Their Shareholders 65

Taxation of Investment Companies: Subchapter M and Regulated Investment Company (RIC) Requirements 65

The Mechanics of RIC Shareholder Capital Gains Taxation 73

The Wash Sale Rule 81

Other Pass-Through Collective Investment Vehicles 82

The Relative Tax-Efficiency of Mutual Funds, Exchange-Traded Funds, and Portfolio Baskets 90

Deferral of Long-Term Capital Gains 93

Outlook for Changes in Investment Company Taxation 98

Chapter 5 The Economics of Indexing, Trading Transparency, and Limited-Function Active Management of ETFs 101

Indexing Works Best When Approached with Common Sense 102

The Continuum: From Passive to Active 108

Benefits from a Decline in ETF Trading Transparency 110

How Trading Plans Become Transparent 112

Effect of Transparency Costs on Fund Performance 121

Silent (Nontransparent) Indexes 124

A Battle of Contrasting Index Fund Management Strategies 126

Chapter 6 Fund Ratings and Rankings—The Evaluation and Selection of ETFs and Mutual Funds 131

An Introduction to Fund Ratings 131

Wanted: A Comprehensive But Eclectic Approach to Fund Evaluation and Analysis 140

Measuring and Comparing Fund Performance 141

A Perspective on the Limitations of Fund Analysis Today 142

Elementary Fund Economics 146

The Largest Cost for Most Funds is Not Reported to the Fund’s Investors 149

What is Tracking Error? 155

Net Tracking Error as a Framework for Fund Performance Evaluation 161

Positive (Value-Added) Elements 168

eXtensible Business Reporting Language (XBRL): The New Data Standard 170

There is a Wide Range in the Quality of Fund Touts, Tools, and Techniques 172

Fund Governance 179

Chapter 7 How Will Full-Function Actively Managed ETFs Work? 183

The SEC Concept Release and Limited-Function Actively Managed ETFs 183

Chapter 8 How to Minimize Your Cost of Trading ETFs 197

ETF Trading is Different from Stock Trading 197

ETF Intraday Net Asset Value (NAV) Proxies 200

The Brave New World of High-Frequency Electronic Trading 202

ETF Trading Volume is Huge, Growing, and Highly Concentrated 207

How to Trade ETFs Efficiently 208

Market-on-Close (MOC) Transactions in ETFs 210

Introducing NAV–Based Trading in Exchange-Traded Funds 218

Conclusion 224

Chapter 9 Economics and Market Effects of ETF Short Selling 227

Understanding the Risks of Selling ETFs Short 227

The Implications of ETF Short Selling 231

ETF Short Selling for Traditional Investors 234

Chapter 10 Leveraged Long and Inverse Exchange-Traded Funds 245

Trading Sardines 245

How Leveraged Long and Leveraged Inverse ETFs Construct Their Portfolios 246

Is It Useful to Describe Leveraged Fund Returns as Path Dependent? 254

Leveraged Fund Return Patterns 255

Taxation and Distributions from Leveraged ETFs 259

Other Issues Affecting Leveraged ETFs 260

Another Way to Obtain Leverage Without Borrowing 261

The Bottom Line on Leveraged ETFs 262

Chapter 11 ETF Applications for Individual Investors and the Advisors Who Serve Them 263

Short-Term ETF Trading Sometimes Makes Sense 265

ETFs as Portfolios and as Components 266

Integrating Diverse Family Accounts 267

Tax Management 268

Other Tax Issues 270

Thinking Outside the Box 274

Measuring the Comparative Economics of Trading and Holding Different Components of an Index Arbitrage Complex 275

Chapter 12 ETFs for Investors Living Outside the United States 279

Some Features of the ETFs Described in This Book Are Not Universal 279

Chapter 13 A Few Things Everyone Should Know about Investment Returns and Retirement 285

Chapter 14 Where to Look for Help in Using ETFs 293

Sources of Professional Help 293

The Advisory Relationship 296

Sources of ETF Information 298

Bibliography 303

Glossary 313

About the Author 351

Index 353