Exchange-Traded Funds Manual

GARY L. GASTINEAU is principal of ETF Consultants LLC, which provides specialized exchange-traded fund consulting services to ETF issuers, exchanges, and investors. He is also a managing member and cofounder of Managed ETFs LLC, a firm that has developed new ETF trading systems and new actively managed ETFs. Preceding a position as managing director for ETF product development at N veen Investments, Gastineau directed product development at the American Stock Exchange for approximatel five years. He is also the author of the first edition of The Exchange-Traded Funds Manual and Someone Will Make Money on Your Funds—Why Not You? (both published by Wiley) and The Options Manual, as well as coauthor of the Dictionary of Financial Risk Management. Gastineau is an honors graduate of Harvard College and Harvard Business School.

• Preface ixAcknowledgments xiChapter 1 An Introduction to Exchange-Traded Funds 1Exchange-Traded Funds Were Introduced as “Something to Trade” 1Shareholder Protection 3Tax Efficiency 7Cost Transparency is Desirable, But Trading Transparency is Costly 9Intraday ETF Trading 10Comparing ETF and Mutual Fund Economics 11Conclusion 17Chapter 2 The History and Structure of Exchange-Traded Funds—and Some of Their Competitors 19Some Major Financial Market Developments (1975 to 2000) 19Declining Trading Costs Increase Financial Engineering Opportunities, and Financial Engineering Reduces Trading Costs in the New Millennium 23A Brief History of ETFs 25Other Tradable Basket Products 34Chapter 3 The Regulatory Framework and Mechanics of the Open-End ETF 43U.S. Fund Regulation Has Played a Major Role in the Structure of ETFs Introduced around the World 43The Investment Company Act of 1940 45Exemptions from the Investment Company Act of 1940Have Been Granted to Permit Issuance of Open-End ETFs 47ETF Developments Outside North America 50Proposed Rule 33-8901 and Limitations on ETFTrading Transparency 53The Mechanics of ETF Creation and Redemption In-Kind 53Chapter 4 Taxation of ETFs and Their Shareholders 65Taxation of Investment Companies: Subchapter M and Regulated Investment Company (RIC) Requirements 65The Mechanics of RIC Shareholder Capital Gains Taxation 73The Wash Sale Rule 81Other Pass-Through Collective Investment Vehicles 82The Relative Tax-Efficiency of Mutual Funds, Exchange-Traded Funds, and Portfolio Baskets 90Deferral of Long-Term Capital Gains 93Outlook for Changes in Investment Company Taxation 98Chapter 5 The Economics of Indexing, Trading Transparency, and Limited-Function Active Management of ETFs 101Indexing Works Best When Approached with Common Sense 102The Continuum: From Passive to Active 108Benefits from a Decline in ETF Trading Transparency 110How Trading Plans Become Transparent 112Effect of Transparency Costs on Fund Performance 121Silent (Nontransparent) Indexes 124A Battle of Contrasting Index Fund Management Strategies 126Chapter 6 Fund Ratings and Rankings—The Evaluation and Selection of ETFs and Mutual Funds 131An Introduction to Fund Ratings 131Wanted: A Comprehensive But Eclectic Approach to Fund Evaluation and Analysis 140Measuring and Comparing Fund Performance 141A Perspective on the Limitations of Fund Analysis Today 142Elementary Fund Economics 146The Largest Cost for Most Funds is Not Reported to the Fund’s Investors 149What is Tracking Error? 155Net Tracking Error as a Framework for Fund Performance Evaluation 161Positive (Value-Added) Elements 168eXtensible Business Reporting Language (XBRL): The New Data Standard 170There is a Wide Range in the Quality of Fund Touts, Tools, and Techniques 172Fund Governance 179Chapter 7 How Will Full-Function Actively Managed ETFs Work? 183The SEC Concept Release and Limited-Function Actively Managed ETFs 183Chapter 8 How to Minimize Your Cost of Trading ETFs 197ETF Trading is Different from Stock Trading 197ETF Intraday Net Asset Value (NAV) Proxies 200The Brave New World of High-Frequency Electronic Trading 202ETF Trading Volume is Huge, Growing, and Highly Concentrated 207How to Trade ETFs Efficiently 208Market-on-Close (MOC) Transactions in ETFs 210Introducing NAV–Based Trading in Exchange-Traded Funds 218Conclusion 224Chapter 9 Economics and Market Effects of ETF Short Selling 227Understanding the Risks of Selling ETFs Short 227The Implications of ETF Short Selling 231ETF Short Selling for Traditional Investors 234Chapter 10 Leveraged Long and Inverse Exchange-Traded Funds 245Trading Sardines 245How Leveraged Long and Leveraged Inverse ETFs Construct Their Portfolios 246Is It Useful to Describe Leveraged Fund Returns as Path Dependent? 254Leveraged Fund Return Patterns 255Taxation and Distributions from Leveraged ETFs 259Other Issues Affecting Leveraged ETFs 260Another Way to Obtain Leverage Without Borrowing 261The Bottom Line on Leveraged ETFs 262Chapter 11 ETF Applications for Individual Investors and the Advisors Who Serve Them 263Short-Term ETF Trading Sometimes Makes Sense 265ETFs as Portfolios and as Components 266Integrating Diverse Family Accounts 267Tax Management 268Other Tax Issues 270Thinking Outside the Box 274Measuring the Comparative Economics of Trading and Holding Different Components of an Index Arbitrage Complex 275Chapter 12 ETFs for Investors Living Outside the United States 279Some Features of the ETFs Described in This Book Are Not Universal 279Chapter 13 A Few Things Everyone Should Know about Investment Returns and Retirement 285Chapter 14 Where to Look for Help in Using ETFs 293Sources of Professional Help 293The Advisory Relationship 296Sources of ETF Information 298Bibliography 303Glossary 313About the Author 351Index 353