Exchange-Traded Funds as an Investment Option

There are two major schools of thought underlying portfolio strategy. The first is an active portfolio management strategy, which believes that investments should be managed with the objective of achieving a rate of return that surpasses a given benchmark. Essential to this strategy are expectations about the factors that could determine the performance of an asset class, such as dividends and future earnings for common stocks or future interest rates for bonds.

As we saw in the previous chapter, index funds are an extension of the efficient market theory (EMT). They can represent a broadly diversified portfolio of securities or set themselves narrower objectives by restricting their holdings to match specific sectors or Sub-sectors of the economy. Once investors’ desired risk levels are matched with specific index funds, they trade as little as possible, therefore resulting in relatively low costs.

As an outgrowth of the index fund industry, ETFs now provide investors with practical alternatives to mutual funds. Just like mutual funds, they were developed around the same benchmarks, some of which were described in Chapter 2. The SPDR 500 or SPY is an ETF that attempts to track the S&P 500 index in the same way as the Vanguard 500 index fund. Hence, the ETF educational process, the theme of this book, leads to an inevitable comparison between these two investment categories.

Investment risk can be minimized by diversifying portfolio selections. Mutual funds are considered an effective vehicle to achieve this goal: one share of a mutual fund can represent the ownership of the entire market. However, mutual funds may suffer from a serious disadvantage in terms of capital gain distribution: mutual-fund investors may end up with a heavy tax burden. Exchange-traded funds (ETFs), which came about in 1993 with the launch of the Standard & Poor’s 500 Trust Series 1 (SPDR 500, ticker symbol: SPY), were created to offer not only the same diversification and convenience presented by mutual funds but also to alleviate the tax burden on investors. In this chapter we examine why mutual funds present such a disadvantage in relation to ETFs, by reviewing the relevant tax laws and how ETFs operate to produce the significant tax savings reported by their sponsors. In the next chapter, we put these claims to the test, comparing the actual tax distributions of selected ETFs to those reported by their direct mutualfund counterparts, to determine whether there are tax advantages to report.

In addition to their other advantages described in Chapter 3, ETFs are also acknowledged for their tax benefits. In Chapter 4, we explained the mechanics underlying their potential tax advantage over mutual funds, noting that this benefit derives from their unique creation and redemption process. When investors redeem their ETF shares, they receive shares of the underlying stocks in the index.

Exchange-traded funds (ETFs) have become a mainstream investment tool for both individual and institutional investors. In previous chapters we discussed their numerous advantages over other index funds, such as liquidity, trading flexibility, lower commission fees, and structural tax benefits. We also discussed other features unavailable with mutual funds, such as their ability to be sold short or bought on margin.

We chose to delay the discussion of fixed-income ETFs to Chapter 7 instead of bundling them with the previous chapter. The fact that these products currently represent only a small fraction of the total ETF market should not prevent us from treating them as the full-blown asset class that they really are, thereby worthy of their own chapter.¹ After all, like their bond mutual-fund counterparts, they are quite capable of satisfying investors’ decision making in regard to expectations of higher or lower interest rates, inflation or deflation, recession or economic growth.

This book so far has illustrated one tax advantage that ETFs offer over conventional mutual funds. This advantage finds its source in the fact that mutual funds must sell securities to meet redemptions, thus triggering large capital gains distributions which are passed through to the remaining investors. In contrast, ETF holders are sheltered from this risk because the fund has no need to sell any of the shares comprising the underlying portfolio, due to the in-kind redemption clause.

Overall, this chapter examines the specificities of the European markets in order to determine whether European Exchange traded funds (ETFs) can achieve the same level of success currently experienced by their counterparts in the United States. To start with, some of the main features of ETFs, such as liquidity, transparency, tax efficiency, and relatively low management fees, shown in previous chapters to provide them with a distinct advantage over competing products in the United States, are examined.

One issue that is reshaping investing is the growing globalization of securities markets. By thoroughly describing the overall investment environment of the ETF market in Europe, Chapter 9 has recognized Europe’s growing importance as a key destination for ETF players looking for international investment opportunities, as well as for the European investors who have been embracing in droves these relatively new financial instruments. As such, Chapter 9 has provided a structured framework that logically should provide proper guidance for developing, implementing, and monitoring the investment strategies needed to achieve financial goals.

Over the last decade or so, China’s importance to the world economy has increased substantially. Deemed far too big to ignore, given its outsized growth and the considerable need for capital to fund it, China has been garnering a lot of attention from investors, turning its markets into an increasingly important destination for their investments.

At any point in time, an investment strategy is as good as its ability to take advantage of unusually profitable opportunities or simply reduce exposure to risk. In theory, based on the investor’s expectations of long-term risk and return, such an investment strategy could be implemented with various financial products. In practice, however, its efficiency could be limited by some of the main characteristics of the instruments involved, such as the lack of continuous pricing. Hence, selecting the right instrument is critical in determining how much success an investor will have with his or her chosen investment strategy.

This chapter highlights two ETF trading strategies: one based on futures, where the individual enters a contract to buy or sell ETFs at a specified price and delivery date; and the other on margin trading, in exchange for making a small payment known as the initial margin. This chapter seeks to reduce the abstractions surrounding these two strategies while liberally illustrating the concepts on which they are based, so that ETF investors can thoroughly understand their fundamentals and importance as hedging tools or instruments of speculation.

As exchange-traded funds (ETFs) have grown in popularity, several of these funds have also become optionable. Like futures on ETFs, options on ETFs provide a fast and cost-efficient way of controlling portfolio risk, especially in down markets or particularly volatile markets like those we have been experiencing since the beginning of the decade.