What lies beneath?

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February 21, 2020
 

Many advisors and investors are already familiar with the benefits exchange-traded funds (ETFs) can offer, but complex issues lie just below the surface. Experts from across our company take a deeper look at some of the underlying components that can influence the performance of even the most carefully constructed investment portfolios.

What lies beneath?

A quick Google search of ETFs yields 199,000,000 results in 0.54 seconds. It’s an indication of the size and influence of these investment products—one that shows few signs of slowing. Yet, if an internet search for ETFs generates millions of hits in milliseconds – highlighting just how much is written on these products – and forecasts expect continued growth, why are some investors still passing on the product?

Some argue the frenzy of innovation and interest ETFs are experiencing makes it difficult to keep up, even for seasoned advisors. Widely acknowledged ETF benefits— diversification tool, relatively lower costs, flexibility and tax efficiency—can potentially blind some investors to the more complex issues just below their surface. This includes issues involving the cost components that make up the ETFs themselves. Understanding some of the more unique characteristics of an ETF not only helps make for an apples-to-apples comparison among products, but also with other available investment options.

Creation and redemption

When evaluating the true costs of ETF ownership, it can get complicated. One important reason is the creation and redemption mechanism unique to ETFs.

In the launch of an ETF the first step is for the provider to find a partner with buying power like a market maker/authorized participant (AP).

The ETF provider would give this partner a block of ETF shares (usually around 50,000) – called a creation unit - to sell on the market. In exchange the AP would either pay market value for the shares or more commonly, acquire the securities an ETF wants to buy in the underlying index (an in-kind trade). Both parties benefit from the transaction: the ETF provider gets the stocks it needs to track the index and the AP gets ETF shares it can resell potentially for profit. And because this transaction is an in-kind trade— securities traded for securities rather than cash—in many cases (but not all) there are no tax implications (funds typically incur capital gains taxes by selling a holding for a realized gain). The cost of trading the underlying securities is therefore largely borne by market makers who drive the primary trading of ETFs, rather than by the actual fund.

Redemptions largely work in the same manner, only the reverse.

APs are unique to open-end ETFs and have multiple roles. They assist in creation and redemption units but they also act as a check on ensuring an ETF trades as close to its net asset value (NAV) as possible. They do so by intervening to buy (or sell) when an ETF appears to be on a widening discount or premium.

Some ETFs with low trading volumes may appear to have a lower cost than a comparable one with a higher fee but which is also traded more frequently. Ultimately, the spread that matters most is the one paid at the time of the transaction and that should be weighed against broader aims such as investment goals and objectives.

Know the Way

While changes and transaction costs in ETFs are relatively low in comparison to mutual funds, there are also other nuances to watch out for, particularly in certain, more specialist, types of ETFs.

For more on how ETFs work – including tracking errors and bid/offer spreads, see our article 27 years and counting.

So what, ultimately, lies beneath? Some of the issues we discussed may be more important than others at any given time, but all play a role in ETF investing. The key is to be as well informed as possible about both the apparent and underlying factors that influence an ETF’s structure, total cost of ownership and liquidity profile (to name a few) in order to make the most effective decisions possible.

1 The NAV is an expression of the underlying value of the company. That is, it is a statement of the value of the company's assets minus the value of its liabilities

2 A discount or premium to NAV is when a stock (or ETF) is trading at a price that is lower or higher its net asset value (NAV)

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a fund, contact your financial advisor or visit im.bnymellon.com. Please read the prospectus carefully before investing.

ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETF's per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF's shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.

ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.

Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis.

Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees. Small and midsized company stocks tend to be more volatile and less liquid than larger company stocks as these companies are less established and have more volatile earnings histories.

Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.

Past performance is no guarantee of future results.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular investment, strategy, investment manager or account arrangement. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation.

Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. BNY Mellon ETF Investment Adviser, LLC is the investment adviser and BNY Mellon Securities Corporation is the distributor of the ETF funds, both are subsidiaries of BNY Mellon.

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