Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded funds (ETFs) became a topic that is a potential test item students may see on their exam. You can read more about ETFs in our Study Manual, but let’s visit them briefly here.
Exchange-traded funds are investment companies, either open-end or unit investment trusts, that differ from mutual funds in the way they are issued, traded, and redeemed. Investors can buy ETFs that track essentially every sector of the equities markets, as well as ones for fixed-income securities, commodities, currencies, metals, and hedge funds. Most recently, ETFs have been created that are leveraged 2 or 3 times to an index, as well as ones that are leveraged to the inverse of an index. We will discuss leveraged and inverse ETFs and the concerns they raise in a separate blog. For now, we will focus on traditional ones and the ways they differ from mutual funds.
One disadvantage of a mutual fund is that there is no secondary market for its shares. Shares can be redeemed only by the mutual fund company. Since shares must be redeemed at the fund’s closing net asset value (forward pricing), the investor does not know the full redemption value of the shares until the market closes for that day.
The inconvenience of forward pricing may be apparent especially in circumstances where an investor is engaging in a same-day substitution, selling a mutual fund with the intention of using the proceeds for the purchase of another securities product. If the full redemption price of the mutual fund is not known, it is difficult to invest in another product simultaneously with the sale of the fund. This problem is most critical in a tax-deferred account where the customer may have limited funds to invest without making additional contributions.
ETFs do not have forward pricing. They trade in the secondary market and can be purchased or sold anytime throughout the trading day. Therefore, the liquidation value is known immediately and the investor can reinvest the proceeds without delay. It is easy to move in and out of most ETF positions. However, this ease of purchasing and selling ETF shares can cause inexperienced individuals to make inappropriate trading decisions. They may find themselves entering and exiting a position more frequently than necessary, generating excessive commissions that outweigh any gains they may have realized.
There are management fees and administrative costs associated with both mutual funds and ETFs. These fees and costs increase the expense ratios of both. Active management results in higher management fees and administrative costs. Actively managed mutual funds have the highest expense ratios. Passively managed index mutual funds have expense ratios that are lower than actively managed funds because management fees and administrative costs are lower.
Since mutual funds are purchased and redeemed directly from the issuer, they may not be sold short. Selling short and rapidly covering is attractive to the short-term trader, and also to a money manager who wants to take short positions in overvalued sectors to hedge long bets made on stocks. Since ETFs may be sold short, they have an advantage over mutual funds.
Mutual funds may not be purchased on margin. ETFs may, and, in the hands of experienced investors, can enhance returns. If the wrong investment decisions are made, however, margin can amplify losses and have a negative impact on an investor’s portfolio. Consequently, the use of margin may be suitable for some investors but not for others.
An actively managed fund will produce capital gains as its managers buy and sell stocks, which the fund must pass on to its shareholders once each year. This means that investors may incur capital gains taxes even if the net asset value of the mutual fund has actually declined in value or remained the same.
As with index funds, ETFs tend to minimize capital gains taxes since their turnover is usually low. ETFs can be redeemed the same way, minimizing the purchase and sale of securities within the fund. Traditional ETFs will remove securities and replace them only when the underlying index changes and the fund must rebalance its holdings.
While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETFs.
Thanks for spending time with us. We hope you found it worthwhile.
—Securities Training Corporation