ETF No Longer Means Index Fund

by Rick Ferri

Exchange-traded funds (ETFs) started out linked at the hip to low-cost, market-tracking index funds. The only ETFs available during the 1990s were those that followed well-known benchmarks such as the S&P 500 (ticker: SPY) and the Nasdaq 100 (ticker: QQQQ). That’s no longer the case.

Today, the ETF acronym is being used broadly by the fund industry and media outlets to include non-fund product structures and active management strategies. This usage has created confusion in the marketplace and isn’t healthy, in my opinion. It’s like saying the Dow Jones Industrial Average is the stock market.

The exchange-traded product (ETP) marketplace has evolved since the 1990s. Most ETPs are classified as ETFs, meaning they follow an Investment Company Act of 1940 structure. However, several other non-fund ETP structures have been created, and they too are lumped under the ETF acronym. This makes for investor confusion.

The ETF acronym has become a catchall by the industry and the media for any exchange-traded product  that has a creation and redemption feature. This operational process allows for the number of shares outstanding of a product to change during a trading day depending on supply and demand needs.

The creation and redemption feature makes ETPs distinctly different from closed-end funds (CEFs). CEFs have a fixed number of shares outstanding, which can lead to large discounts and premiums in market pricing relative to net asset value (NAV). The ability to create and redeem ETP shares intraday significantly reduces the spread between market price and NAV.

There are several types of exchange-traded products  available to investors. They include exchange-traded notes (ETNs), grantor trusts, limited partnerships and 1940 Act funds (ETFs). Each structure has different underlying features, operational challenges, regulatory controls, and the tax treatment for income distributions and capital gains are different.

Vanguard has recently published a guide to help sort ETP differences. ETF structures at-a-glance is a handy reference piece that summarizes the key regulatory and tax features of each structure. You can find detailed analysis of each structure in The ETF Book.

I think it’s noteworthy that Vanguard is labeling all ETP structures as ETFs in the title of its guide. That’s not correct, but neither is the whole ETF acronym situation. Vanguard’s just trying to get people to use their guide.

Most assets in ETFs are tracking capitalization-weighted market indexes. These are familiar indexes that we’re all familiar with. ETFs that track market benchmarks have significantly more assets in them than ETFs that employ other strategies, and continue to attract most of the new asset flow according to Morningstar. The S&P 500 is the largest and most popular index in this category.

Non-benchmark following ETFs were introduced in 2003. These “strategy indexes” are quite diverse. They can be anything. The first strategy index ETFs were introduced by InvescoPowershares in 2003. The Dynamic Market Portfolio (PWC) tracks the Dynamic Market Intellidex Index. This is a highly quantitative active management strategy that seeks to identify 100 stocks with “superior risk-return profiles” from among the largest 2000 companies on the market. It’s certainly a far cry from John Bogle style indexing.

Strategy index-tracking ETFs have expanded exponentially over the years. New entrants have come to the market with a range of active management strategies that have been mechanized into indexes and launched as products. The marketing of these products has also taken on a life of its own. Phrases such as fundamentally indexing and smart beta have spun out of these special products. I call this type of marketing SPINdexing for short.

ProShares pushed the envelope further in 2006 with the introduction of leveraged and inverse funds. These ETFs seek returns that are either 3x, 2x, -1x, -2x or -3x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next.

InvescoPowershares was back with new innovation in 2008 with the introduction of the first ETFs that did not track any index. Pure actively managed ETFs follow traditional strategies where an individual or investment committee picked each security by hand. Although none of the PowerShares actively managed ETFs survived, their introduction did break that ice for other ETF companies to come to the market with their own actively managed products.

The ETF acronym is no longer synonymous with low-cost benchmark indexing. Operational structures have expanded well beyond 1940 Act funds and the strategies used in these products have little resemblance to traditional benchmark indexes.

I believe that it’s proper to call products what they are to reduce investor confusion. Will my efforts pay off? Most investors still think the Dow Jones Industrial Average is the stock market. C’est la vie.


Copyright © Rick Ferri

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