Nasdaq Joins In

In 1999, the SEC issued the Nasdaq-100 Trust Order under the unit investment trust structure. While the Nasdaq-100 is similar in structure to the Diamonds, the Nasdaq-100 uses a modified capitalization-weighted index as the underlying index. This modification was done for policy reasons so the Nasdaq-100 ETF itself is indirectly managed in a limited but significant way. The Nasdaq-100 trust gained quick acceptance in the marketplace.

Also in 1999, Barclays Global Fund Advisors applied to the SEC for an Order covering about 50 ETFs. Barclays calls their products "Exchange Traded Funds". Barclays, having learned from its WEBS partnership with Morgan Stanley, uses the investment company structure to create what are best described as enhanced indexes based on Russell, S&P, and Dow Jones Indexes. In its petition to the SEC, Barclays gives itself as much discretion as possible over managing the products while still being able to call the products index-based investments.

HOW EXCHANGE TRADED FUNDS WORK

Overview

The first ETF, LOR's Index Trust SuperUnit, was originally created by a financial intermediary as a security offered to institutional investors. Current ETFs use the same underlying structure as the Index Trust SuperUnit. Thus, the underlying structure of ETFs is very different from the structure of open-ended mutual funds originally designed by investment managers to offer investments to the general public.

Creation Units

Unlike mutual fund distributors, the sponsors of ETFs do not sell ETF shares to the public for cash. Instead, the ETF sponsors exchange large blocks of ETF shares in-kind for the securities of the companies that make up the underlying index plus a cash component representing mostly accumulated dividends. The large block of ETF shares is called a "Creation Unit" which is exchanged for a "Portfolio Deposit" of stock and the "Cash Component".

Some of these institutional investors hold the creation units in their own portfolios. Others, generally broker-dealers, break-up the creation units and offer the ETF shares on the exchanges where individual investors can purchase them from brokerage firms just as they would any other listed security.

ETFs are redeemed the same way but in reverse. Broker-dealers buy enough ETF shares from individual investors to make a creation unit block. The broker-dealers then exchange with the ETF sponsor the creation unit for a basket of securities and the small amount of cash. Other institutional investors will trade back the creation units in their portfolio with the ETF sponsor for securities and cash.

Creation units are continually created and redeemed due to investor demand and for arbitrage purposes. The values of the ETF track closely but do not match exactly the values of the underlying security so institutional investors can measure the price of the underlying securities in the index against the price of the ETF. If the price of the underlying securities is higher than the price of the ETF, the institutional investors will trade a lower-priced creation unit back to the ETF sponsor in exchange for the higher priced securities. Conversely, if the price of the underlying securities is lower than the ETF, the institutional investor will trade back to the ETF the lower-priced securities in exchange for a creation unit. This arbitrage mechanism eliminates the problem associated with closed-end mutual funds - the ETF trading as a premium or discount to the value of the underlying portfolio.

All of these creations and redemptions are very important, not only to keep the price of the ETF properly reflecting the value of the underlying securities, but also for the tax reasons discussed later.

The individual investor can purchase ETF shares through the exchange and the shares might come from either individual investors or from the institutions. It is important to remember that ETFs are not mutual funds and that there is a lot of behind-the-scenes swapping of securities.

CHARACTERISTICS OF ETFs

Regulated Investment Company

Although ETFs are not mutual funds, they are similarly taxed. Both open-ended mutual funds and ETFs structure their operations to qualify as Regulated Investment Companies under the U.S. Tax Code. Thus, neither the open-ended mutual fund nor the ETF has to pay taxes related to the buying, holding, and selling of securities in the portfolio provided the managers distribute nearly all of the capital gains and dividends to the shareholders.

Tax Efficiency

The IRS rules regarding Regulated Investment Companies represents a major flaw when applied to open-ended mutual funds because the only investors who pay taxes on the distributions are the current shareholders. The former shareholders may have benefited from gains that created these distributions but are not responsible for paying their share of these taxes.

Some investment advisors noticed that the ETFs were distributing fewer capital gains than the corresponding mutual funds. Particularly, investment professionals noticed that the S&P 500 Index-based SPDR was distributing smaller amounts of capital gains than the Vanguard 500 Index fund that is also S&P 500-based. Conventional wisdom is that the distributions should be the same because both funds hold the same securities, the returns of the two investments are similar, and both are taxed as Regulated Investment Companies. The discrepancy started an investigation by the investment advisors and the ETF sponsors.

Approx. Capital Gain Distributions as a % of NAV
S&P 400 Index Products

The investigation revealed that the ETFs, unlike the mutual funds, use the swapping mechanism to eliminate the embedded capital gains from the portfolio. Recall that the ETFs do not sell shares directly to the public for cash. Instead, they swap creation units for shares of individual securities. Redeeming works in reverse, the ETF takes in Creation Unit blocks and assigns out shares of securities in the portfolio.

Each of the individual securities held by the ETF has an associated tax basis. Some clever operations staff began assigning out the lowest cost basis securities in the portfolio during the redemption process. Thus the redeeming institutional investors, not the remaining beneficial shareholders, are responsible for the taxes. Due to the redemption process, the ETF ends up with a higher tax-basis portfolio and fewer capital gains to distribute.

As soon as the tax saving idea was more widely known, the ETF sponsors began a concerted effort to get rid of all the embedded taxes. However, it was too late for some of the ETFs to avoid some significant distributions.

The previous discussion concerned taxable capital gains distributions caused by investors redeeming fund shares. Changes to the underlying indexes can also cause taxable capital gains distributions. When the underlying index changes, index funds are forced to sell the outgoing position and buy the incoming position. The sale of the outgoing position can cause large capital gains distributions.

EFTs, like mutual funds, used to sell the outgoing securities resulting in capital gains distributions. Then, EFT staff began to assign out these securities too during the redemption process avoiding the need to sell them and realize capital gains. Again, the operational change came too late in some cases to avoid some distributions.

With ETFs, as long as there are enough creation units being redeemed to allow the assigning out of low cost-basis or otherwise unneeded securities, the ETFs will no longer need to make capital gains distributions.

Expenses

ETFs generally have expenses that are similar to low-cost, no-load, index-based mutual funds.

Other Features of ETFs

ETFs allow investors to:

• Trade the "market" with a single investment as easily as trading a stock.
• Price, buy and/or sell at any time during the trading day
• Margin.
• Sell short. (ETFs can be sold short on a downtick).
• Execute all order types.

ETFs COMPETE WITH MUTUAL FUNDS

ETFs, which started out as underlying securities for hedge products, have evolved over time to become products that resemble and compete against open-ended mutual funds. It is difficult to predict the ultimate success of the ETFs in part of their novelty and limited availability. At the same time, the mutual fund and brokerage industry is changing partly due to the popularity of the ETFs.

Competition on All Fronts

Before we can appreciate the effect ETFs are having on mutual funds, it is important to understand the competitive forces in the investment arena. Simply, there are primarily two parties to an institutional investment transaction: the investor buying and selling an investment and the intermediary that acts as an agent to obtain that investment for the investor. Mutual funds, money managers, etc. are the investors. The stock exchanges, electronic and otherwise, are the intermediaries.

For some time a status quo existed between the two parties. Mutual funds offer shares directly to the public and compete with the stock exchanges. Mutual fund managers also purchase large blocks of shares through the exchanges and are large exchange customers as well. This status quo worked reasonably well while the mutual funds grew and the trading volume on the exchanges increased.

Today, the competitive environment for both the exchanges and the mutual funds is more difficult. The competition is increasing between the major exchanges (Nasdaq vs. NYSE) as well as the major and minor exchanges (AMEX vs. Pacific). The exchanges are losing transaction volume to index funds that systemically produce lower trading volume. Brokerage houses began to offer investors mutual funds at the expense of exchange-traded securities. Finally, some investment firms and mutual fund companies are creating proprietary exchanges as a cost-saving measure and to eliminate the traditional exchanges all together. Spear, Leeds & Kellogg; Fidelity Investments; Donaldson, Lufkin & Jenrette; and Charles Schwab & Co. recently announced the latest venture to offer trading outside the exchanges.

Retail Mutual Fund and Brokerage Industry Give ETFs a Chance

While there are some notable exceptions, the mutual fund industry has for years balked at making structural changes. It resists lowering costs and has not effectively addressed the widely criticized tax issues. At the same time, it has taken other steps to make investing in mutual funds less investor friendly, such as adding redemption fees. Indeed, failing to correct structural flaws in the mutual fund industry, the funds themselves have helped spawn the ETFs.

A similar argument holds for the transaction-oriented retail brokerage industry. Poor stock selection, excessive trading, poor customer service, and excessive costs have plagued the brokerage industry. These conditions create an ideal environment for ETFs to grow. The effect that this has on the retail brokerage industry is more threatening than it is for the mutual fund industry. Investors now replace 500 brokerage transactions with one ETF transaction, thereby reducing the brokerage requirements of individual investors by a similar ratio. The mutual fund industry, on the other hand, may be able to switch to an ETF format, or to respond by lowering fees and providing better service.

ETFs Are Starting To Have an Impact

According to the American Stock Exchange, SPDRs have $14 billion in assets. In contrast, the Vanguard 500 Index Fund, the granddaddy of S&P 500 index funds, has $92.5 billion in assets. Yet, the Vanguard fund existed since 1976 while the SPDR has been offered only since 1993. The SPDR would already rank among the 15 largest domestic stock mutual funds.

Source: Barrons, Morningstar, American Stock Exchange, New York Times

Growth of Exchange Traded Funds

It seems logical that more and more companies will look to sponsor ETFs. Barclays has filed with the SEC to offer more than 50 new ETFs. Recently, Solomon Smith Barney has filed to offer an Internet ETF.

MUTUAL FUNDS FIGHT BACK

Mutual Fund Families Consider Introducing ETFs

Mutual fund managers have taken notice of the ETF both from a technical perspective and as a new distribution channel for money management services. From a technical perspective, mutual fund companies are trying to devise ways to use in-kind exchanges to help wash out realized capital gains. Mutual fund families are also looking at converting some of their index funds to ETFs.

Managed funds are also looking at converting to an ETF status. However, this raises some issues including those relating to transparency. (It is difficult if not impossible to hide security selection in an ETF.) Instead, the next step forward may be more enhanced and sector indexes as well as quantitative-oriented funds. None of these products rely on stock selection as a competitive advantage.

Mutual fund managers are also pointing out ETFs weaknesses:

• It is difficult (and potentially expensive) to set up a systematic purchase agreement into an ETF. (Each ETF purchase is subject to a brokerage fee.)
• There is no toll free number to get any help or advice with an ETF. A broker or investment advisor may be needed for all but the die-hard do-it-yourself investors.
• The mutual funds settle in one day vs. three days for an ETF. ETF investors must wait two extra days to get the proceeds of selling the investment.
• Mutual funds can out-perform ETFs in a rising market because mutual funds reinvest dividends continuously while ETFs generally invest dividends on a quarterly basis. Thus, cash positions can build up in an ETF which are not subject to market growth.
• Mutual funds have a bigger marketing budget than ETFs at this time.

There appears to be room in the marketplace for both mutual fund and ETF versions of popular index investments.

CONCLUSION

ETFs are here to stay. They have technical advantages over mutual funds and have shown an ability to capture investors' dollars. They are a good investment for suitable individual investors and are a good investment tool for investment professionals. There is a demand in the retail sector for more products that use well-known indexes. There is a growing demand in the investment advisory sector for a wider selection of ETFs using more obscure indexes. Firms such as Barclays and Solomon Smith Barney are taking steps to offer these products.

However, the future relationships between broker-dealers, ETF sponsors, mutual funds, and exchanges seem uncertain. Also, the retail demand for ETFs built around the more esoteric indexes and quantitative methodologies appears uncertain as well.