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Look to the future together - ETF.com
T H E M A G A Z I N E F O R E T F I N V E S T O R S ////////////////////////////////////////////////////
                                                           B:9”                                          JANUARY 2020
                                                 A D V E R TS:8”

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There are risks involved with investing in ETFs, including possible loss of money. ETFs are subject to risks similar to
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more greatly impacted by market volatility, than more diversified investments.
The Nasdaq-100 Index comprises the 100 largest non-financial companies traded on the Nasdaq.
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Look to the future together - ETF.com

                                                         The Possibility Of
                                                         Fractional Shares

                                                         An ETF Primer

                                                         Glossary of ETF Terms

                                                         A Legend Retires

                                                         Canada In Focus

                                        ETF UNIVERSITY

                   ETF.com/ETF Report                        PUBLISHED BY
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Look to the future together - ETF.com
VO L U M E 2 0 | N O . 1
                                        F E AT U R E S

                          12            ETF University: Promise Of Fractional ETF Shares
                                        Fractional ETF shares could be a game changer for the proliferation of ETFs
                                        By Lara Crigger

                          16            ETF University: Getting Started
                                        A primer on what investors should know before they invest in ETFs
                                        By ETF.com Staff

                          32            Jim Ross: A Legend Retires
                                        One of the driving forces behind the first U.S. ETF heads into the sunset
                                        By Cinthia Murphy

                          36            2020 Canada Supplement
                                        An overview of the Canadian ETF market, plus a directory of key contacts

                                            DE PART ME NTS
             Noel d’Ablemont Smith
                     nsmith@etf.com             6 E
                                                   TF Launches: FCPI                                          Sectors In Review
             MANAGING DIRECTOR                      Fidelity ETF targets stocks                                   Sector ETFs had a great month, with
                       Dave Nadig                   benefiting from inflation                                     most seeing positive returns
                   REPRINT SALES
                                                  ETF Explainer: IHF
                                                8	                                                            Countries In Review
                                                    A health care provider ETF had a                              Most emerging markets took a hit
                        Drew Voros
                                                    wild 12-month ride                                            during November
               MANAGING EDITOR                   Data At A Glance
                                              10	                                                             ETF Data
                        Heather Bell                A look at the performance of                                  Our monthly databank breaks down
                      COPY EDITOR                   Saudi Arabia, fixed income                                    ETF and ETN returns for every market
                            Lisa Barr               and small caps vs. large caps                                 segment
                 HEAD OF DESIGN
                   Patrick Hamaker               Industry Insight
                                              48	                                                             The Last Word
                            ETF.com                 How small institutions use ETFs                               ETF.com Managing Director Dave
          17 State Street, 32nd Floor                                                                             Nadig on understanding new
               New York, NY 10004
                       www.ETF.com               Commodities In Review
                                              50	                                                                investors’ qualms
                                                    November was a mixed month for
                                                    commodity ETFs

                                        © 2020 ETF.com. All rights reserved. The text, images and other materials contained or displayed are proprietary to ETF.com, except
                                        where otherwise noted, and constitute valuable intellectual property. No material from any part of any ETF.com publication, product,
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                                        to photocopy and use material electronically, please contact sales@ETF.com or call 646-558-6985.
NEW FUNDS                                                                                                                                                         By Heather Bell

                                                                   3%                                                                           ETF FILING ACTIVITY
                                                                   ASSET ALLOCATION
                                      3%                                         1%
                                      INTL FIXED INCOME                          COMMODITIES                                                    U.S. EQUITY
                                                                                                                                                Fidelity Stocks for Inflation
                          5%                                                               1%                                                   FT Cboe Vest US Equity Buffer - Aug
                          INVERSE                                                          ALTERNATIVES
                                                                                                                                                FT Cboe Vest US Equity Buffer - Nov
                                                                                                                                                FT Cboe Vest US Equity Deep Buffer - Aug
                                                                                                                                                FT Cboe Vest US Equity Deep Buffer - Nov

                          6%                                                                                                                    Innovator S&P 500 Buffer - Nov
                          LEVERAGED                                                                                                             Innovator S&P 500 Power Buffer - Nov
                                                                                                                                                Innovator S&P 500 Ultra Buffer - Nov
                          17%                                                                         US EQUITY                                 MicroSectors FANG+ ETN
                          US FIXED INCOME                  YEAR TO DATE                                                                         ProShares Russell US Dividend Growers
                                                                                                                                                ProShares S&P Tech Dividend Aristocrats

                                                                                                                                                U.S. FIXED INCOME
                                                                                                                                                AAM Low Dur Preferred/Income Sec
                                                                                                                                                WisdomTree Mortgage Plus Bond

                                                                 25%                                                                            INT’L EQUITIES
                                                                 INT’L EQUITY                                                                   Defiance Next Gen Food/Ag ETF
                                                                                                                                                SmartETFs Smart Transportation/Tech
             F E AT U R E D E T F
                                                                                                                                                Direxion Daily Dow Jones Internet Bear 3X
              Fidelity Stocks For Inflation ETF (FCPI)                                                                                          Direxion Daily S&P 500 High Beta Bear 3X

              New fund seeks to target sectors and stocks that do well as inflation rises                                                       LEVERAGED
                                                                                                                                                Direxion Daily Dow Jones Internet Bull 3X
              In November, Fidelity launched an equity                    increasing inflation.
                                                                                                                                                Direxion Daily S&P 500 High Beta Bull 3X
              ETF that is supposed to outperform the                           FCPI tracks the Fidelity Stocks for Infla-
                                          broad market in times           tion Factor Index, which has a structural                             ASSET ALLOCATION
Quick View
                                          of increasing infla-            tilt toward inflation-sensitive sectors. The                          Strategy Shrs Newfound/ReSolve Robust Momntm
ISSUER        Fidelity
                                          tion via a factor-based         index selects its roughly 100 components
SEGMENT       Equity: U.S. - Total Market strategy. The Fidelity          based on their factor scores from the larg-                           SELECTED CLOSURES
EXPENSE RATIO 0.29%                       Stocks For Inflation            est 1,000 stocks in the U.S. market.                                  Cushing Energy & MLP
                                          ETF (FCPI) tracks an                 Components are equal weighted, with                              Cushing Energy Supply Chain & MLP
STRUCTURE     Open-Ended Fund
                                          index of large and mid-         their weights then adjusted upward if they                            Cushing Transportation & MLP
INCEPTION     11/5/2019                                                                                                                         Cushing Utility & MLP
                                          cap U.S. stocks offering        fall into certain sectors such as energy,
                                                                                                                                                GraniteShares S&P GSCI No K-1
              exposure to the value, quality and momen-                   materials, consumer staples, health care,
                                                                                                                                                InsightShares LGBT Employment Equality
              tum factors.                                                real assets and infrastructure.
                                                                                                                                                InsightShares Patriotic Employers
                   FCPI comes with an expense ratio of                         In early December, the fund included
                                                                                                                                                Xtrackers Barclays Intl Corp Bond Hedged
              0.29% and lists on Cboe Global Markets,                     Microsoft, LyondellBasell Industries and
                                                                                                                                                Xtrackers Barclays Intl Treasury Bond
              the parent company of ETF.com.                              Steel Dynamics among its largest com-
                                                                                                                                                Xtrackers FTSE Emerging Compr Factor
                   The fund aims to capture the perfor-                   ponents.
                                                                                                                                                Xtrackers MSCI South Korea Hedged
              mance of companies in segments of the                            FCPI joins Fidelity’s family of 28 ETFs,                         Xtrackers Russell 2000 Compr Factor
              market that have typically exhibited above                  which have a total of $2.7 billion in assets
              average performance during times of                         under management.

                                                          Source: ETF.com. Data and information as of 11/30/2019. ETF Filings sidebar covers launches and closures for the month of November 2019.
     6   ETF.com/ETF Report
+ Independent perspective

                                                                                                             + Unrivaled liquidity

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market indices                                                                                  + Unsurpassed credibility

S&P Dow Jones Indices has achievedADVERTISEMENT
iconic status for good reason.

                                                                              + Powerful methodologies

Copyright © 2019 S&P Dow Jones Indices LLC. All rights reserved. S&P® and Indexology® are registered trademarks of Standard & Poor’s Financial Services
LLC. Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. It is not possible to invest directly in an index. S&P Dow Jones Indices
receives compensation for licensing its indices to third parties. S&P Dow Jones Indices LLC does not make investment recommendations and does not
endorse, sponsor, promote or sell any investment product or fund based on its indices.
I N D E TA I L                                                                                                                                      By Heather Bell

ETF Explainer: IHF
iShares U.S. Healthcare Providers ETF
Each month, we look at an ETF selected by ETF.com based on its performance and importance to investors. This month,
we consider the performance of the $883 million iShares U.S. Healthcare Providers ETF (IHF), which covers U.S. companies
offering health care services. All the companies mentioned below are holdings in IHF, unless otherwise noted (*).


                                                    Quick View                                                                                                               1.53%
                                                    ISSUER           BlackRock
       0                                                             Equity: U.S. Health Care
                                           FEB                       Providers & Services
                                                    EXPENSE RATIO    0.43%                               JUL
                                   JAN                                                                    11                                                  NOV
                                                    AUM              $883 Million
      -5                           30                                                                                                                           6
                                                    COMPETING FUND XHS




             DEC             JAN         FEB      MAR          APR            MAY               JUN        JUL        AUG              SEP          OCT             NOV

      JAN    Anthem exceeds expectations for its fourth-quarter revenue                JUL        UnitedHealth Group’s stock rises more than 5% after the

     30      and earnings, and issues a better-than-expected earnings
             forecast, boosting its stock significantly.
                                                                                       11         Trump administration walks back its proposed plan to halt
                                                                                                  the rebates paid to insurance companies by drugmakers.

      FEB    CVS’ stock price plunges after the company issues a lower-than-           SEP        Cigna announces a plan to fully cover gene therapy treatments

     20      expected earnings forecast for 2019. The expectations suggest
             CVS is still dealing with the challenges of its Aetna acquisition.
                                                                                        5         and provide increased access for its members to the expensive
                                                                                                  therapies, sparking a multiday increase in its stock price.

      APR    HCA Healthcare’s share price sinks more than 10% on                       NOV        Humana reports strong third-quarter results, exceeding

     16      worries that Medicare-for-all legislation promoted by multiple
             presidential candidates could damage the company’s future.
                                                                                        6         analyst expectations, and says the layoffs of 800 employees
                                                                                                  announced previously were part of a cost-saving effort.

                                                                                                                            Source: Bloomberg. Data for 11/30/2018 to 11/30/2019.
8   ETF.com/ETF Report
Income Rooted
         in Strength.


         VanEck Vectors Morningstar
         Durable Dividend ETF                                                      ADVERTISEMENT

         Approach dividend investing from a position of strength. Powered by Morningstar’s forward-looking
         research, DURA provides exposures to companies with high dividend yields, financial strength, and
         attractive valuations.

         Call us at 800.826.2333                                                                                                        vaneck.com/durabledividend
Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Vectors Morningstar Durable Dividend ETF and bears no liability with respect to that ETF or any security.
An investment in the Fund may be subject to risks which include, among others, investing in the consumer staples, energy, health care, and utilities sectors, small and medium-
capitalization companies, equity securities, dividend paying securities, market, operational, high portfolio turnover, index tracking authorized participant concentration, no guarantee of
active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversified, and concentration risks, which may
make these investments volatile in price or difficult to trade.
Fund shares are not individually redeemable and will be issued and redeemed at their net asset value (NAV) only through certain authorized broker-dealers in large, specified blocks of
shares called “creation units” and otherwise can be bought and sold only through exchange trading. Shares may trade at a premium or discount to their NAV in the secondary market.
You will incur brokerage expenses when trading fund shares in the secondary market. Past performance is no guarantee of future results.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds
carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com. Please read it carefully
before investing.
Van Eck Securities Corporation, Distributor, 666 Third Avenue, New York, NY 10017
DATA AT A G L A N C E                                                                                                                              Compiled by Heather Bell

M O N T H LY F LOWS                                                                                            INTERESTING CHARTS OF PAST 12 MONTHS

Below are the ETFs that experienced the top and bottom flows for the month                                     The below graphs highlight some of the key
of November, as well as the net flows for major asset classes during the month.                                ETF trends of the past 12 months.

TICKER                             FUND                           ISSUER          NET FLOWS ($M) AUM ($M)                                      iShares MSCI Saudi Arabia ETF           KSA
 IEFA      iShares Core MSCI EAFE ETF                           BlackRock            2,520.53      71,405.73
                                                                                                                VS.                  iShares Core MSCI Emerging Markets ETF            IEMG
 VOO       Vanguard S&P 500 ETF                                 Vanguard             1,836.48     126,826.59   KSA started strong during the 12-month period, outperforming IEMG until
  XLF      Financial Select Sector SPDR Fund                    SSGA                 1,448.48      26,297.78   a September drone attack on some of its oil processing facilities.

 SPY       SPDR S&P 500 ETF Trust                               SSGA                 1,358.82     286,459.89   RETURN
 EWJ       iShares MSCI Japan ETF                               BlackRock            1,353.90      14,486.37      25
 QUAL      iShares Edge MSCI U.S.A. Quality Factor ETF          BlackRock            1,119.97      15,207.97      20
 AGG       iShares Core U.S. Aggregate Bond ETF                 BlackRock            1,059.71      67,184.97
 VYM       Vanguard High Dividend Yield ETF                     Vanguard             1,037.42      28,465.83       5
 SIZE      iShares Edge MSCI U.S.A. Size Factor ETF             BlackRock            1,008.14       1,456.95
 BND       Vanguard Total Bond Market ETF                       Vanguard              940.38       47,468.50     -10
                                                                                                                        D     J   F       M     A     M     J     J     A    S     O     N

TICKER                             FUND                           ISSUER          NET FLOWS ($M) AUM ($M)                                      Vanguard Total Bond Market ETF          BND
                                                                                                                VS.                       iShares 20+ Year Treasury Bond ETF           TLT
 SDY        SPDR S&P Dividend ETF                              SSGA                 -1,164.79      19,700.10
     TLT    iShares 20+ Year Treasury Bond ETF                 BlackRock             -953.89       17,699.91   The broad bond market has exhibited impressive performance during the
                                                                                                               past 12 months, but TLT’s long-term exposure has driven even better returns.
 GLD        SPDR Gold Trust                                    SSGA                  -891.71       41,914.72
     IVV    iShares Core S&P 500 ETF                           BlackRock             -691.67      197,046.03     35%
 SPLV       Invesco S&P 500 Low Volatility ETF                 Invesco                -681.18      12,462.59     30

 MDY        SPDR S&P Midcap 400 ETF Trust                      SSGA                   -663.87      18,967.48     25
 SCHO       Schwab Short-Term U.S. Treasury ETF                Charles Schwab         -579.46       5,164.70
 VCIT       Vanguard Intermediate-Term Corporate Bond ETF      Vanguard               -570.54      25,266.54
 JNK        SPDR Bloomberg Barclays High Yield Bond ETF        SSGA                   -561.01       9,907.28       5
 USMV       iShares Edge MSCI Min Vol U.S.A. ETF               BlackRock             -450.87       36,516.49       0
                                                                                                                        D     J   F       M     A     M     J     J     A    S     O     N

                                              NET FLOWS ($M)       AUM ($M)                 % OF AUM                                                   SPDR S&P 500 ETF Trust          SPY
                                                                                                                VS.                                   iShares Russell 2000 ETF         IWM
 U.S. Equity                                    15,994.72        2,448,894.38                   0.65%
 International Equity                           13,360.50          855,288.42                   1.56%          Although they were neck and neck at the start of the past 12 months,
                                                                                                               small cap IWM has fallen behind large cap SPY in terms of performance
 U.S. Fixed Income                                 6,695.95        747,526.34                   0.90%          during the course of the year.

 International Fixed Income                        2,979.69           87,917.62                 3.39%          RETURN
 Commodities                                     -1,128.27            78,315.69             -1.44%                15
 Currency                                            -89.37            1,406.05             -6.36%
 Leveraged                                         -207.12            37,588.18             -0.55%                 0
 Inverse                                             578.5            12,087.98                 4.79%             -5
 Asset Allocation                                    52.05            10,551.20                 0.49%
 Alternatives                                       229.52             4,637.02                 4.95%            -20
                                                                                                                        D     J   F       M     A     M     J     J     A    S     O     N

                                                                                                                                      Sources: FactSet, Bloomberg; data as of 11/30/2019
10     ETF.com/ETF Report
Whether you’re a novice or seasoned
                                                   The Fight For Fractional
ETF investor, our comprehensive educational                    ETF Trading     12
library is the perfect place to learn about ETFs
                                                                   What Is
                                                                   an ETF?     16
Compiled by the ETF.com Staff

                                                                    What Is
                                                                   an ETN?     17

                                                             Why Are ETFs
                                                           So Tax Efficient?   18

                                                      What Is the Creation/
                                                   Redemption Mechanism?       19

                                                      What Are Authorized
                                                             Participants?     20

                                                     Premiums & Discounts      21

                                                      Managing & Avoiding
                                                             ETF Closures      22

                                                         Securities Lending    23

                                                         Spreads & Volume      24

                                                             ETF Liquidity     25

                                                         Legal Structures,
                                                       Regulations & Taxes     26
EDUCATION                                                        VIX ETFs      27

                                                        Fixed Income ETFs
                                                            During a Panic     28

                                                            Why You Can’t
                                                             Buy Spot Oil      29


                                                                   of Terms

                                                          JANUARY 2020   11

                                                                         EASY FOR MUTUAL FUNDS
                                                                         For a decade or longer, fractional trading has been some-
                                                                         thing of a holy grail for the ETF industry, a deceptively
                                                                         simple concept that’s been exceedingly difficult to put into

                                                                         practice. The reason strikes to the heart of what differenti-
                                                                         ates mutual funds from ETFs.
                                                                              Although mutual funds and ETFs are pooled invest-
                                                                         ment vehicles, investors can only buy in or sell out of
                                                                         mutual funds once per day, after the close of market hours.

              Fight For
                                                                         Once the mutual fund’s net asset value (NAV) is calcu-
                                                                         lated, based on the closing prices of all the securities in
                                                                         its portfolio, the fund manager then creates and redeems
                                                                         shares of the fund in cash. This means any investor want-
                                                                         ing to buy shares gives their cash to the manager, who

                                                                         then creates exactly the amount of shares determined by
                                                                         the NAV. For example, your $150 would buy 1.5 shares of a
                                                                         mutual fund whose NAV is $100.
                                                                              As a result, fractional shares of a mutual fund can and
                                                                         very often do arise, simply to make the bookkeeping work.

          ETF Trading
                                                                         And there’s no problem with execution, because every in
                                                                         and out transaction happens via the fund company itself.
                                                                              ETFs, however, are exchange-traded, meaning
                                                                         their shares are listed on exchanges, and exchanges
                                                                         don’t allow investors to buy partial shares of securi-
                                                                         ties. Whether you’re an authorized participant building
                                                                         a new ETF creation unit or a retail investor purchasing

                   n October, discount brokerage Charles                 shares through their brokerage, you simply can’t buy
                   Schwab made waves when it announced it                fractional shares of an ETF, no more than you could buy
                   planned to introduce trading of fractional            fractional shares of Amazon (AMZN).
                   stock shares in 2020, as part of a broader
              effort to entice younger investors to its platform.        ETFs HAVE A LOWER INVESTMENT THRESHOLD
                  Fractional ETF shares, however, aren’t yet in          Usually this isn’t a problem, given that the bar for invest-
              the cards.                                                 ment in ETFs tends to be lower than for mutual funds.
                  “We are … exploring how fractional share               Typically, ETF investment minimums are much lower than
              trading could be applied in other areas, such as           those for mutual funds, which can cost $1,000, $3,000 or
              with ETFs, but our focus right now is on individual        even $10,000 per share. Even individual stocks can get
              stocks,” Schwab spokesperson Erin Montgomery               pricy; for example, Berkshire Hathaway (BRK) currently
              told ETF Report.                                           costs a whopping $326,100 per share.
                  Fractional trading is considerably more difficult
              to implement for ETFs than it might at first appear,
              and it remains one of the last clear advantages
              mutual funds have over their exchange-listed cous-
                                                                       ETFs WITH THE HIGHEST PRICE PER SHARE                                        FIGURE 1
              ins. Because mutual funds can be bought and sold in
                                                                        TICKER                              FUND                      PRICE PER SHARE
              partial shares, they’ve managed to retain dominance
              in 401(k)s and other retirement accounts, of which         MDY SPDR S&P Midcap 400 ETF Trust                               $360.87
              roughly half of all Americans have.                        ONEQ Fidelity NASDAQ Composite Index Tracking Stock              $333.18
                  So what makes fractional ETF trading so difficult,
                                                                         IVV     iShares Core S&P 500 ETF                                $309.85
              and is there any way to simplify it for the masses?
                                                                         FLGE Credit Suisse FI Large Cap Growth Enhanced ETN              $308.17
              Or is the best solution simply not to bother?
                                                                         SPY SPDR S&P 500 ETF Trust                                      $308.05

                                                                                                                         Source: ETF.com; data as of 12/3/19

     12   ETF.com/ETF Report
Still, for investors with smaller asset prices or precise    accessed outside the context of a brokerage account. This
target allocations, per-share prices of ETFs can get hefty,      means that if a client wants to transfer funds to another
especially for the largest and most liquid legacy ETFs           account or liquidate assets, they’ll likely lose their frac-
with high brand recognition. Several of the top 10 larg-         tional holdings. The partial shares may then be converted
est ETFs are also among the most expensive; the most             to cash or even sold, at which point the investor would be
expensive-per-share ETF is the SPDR S&P Midcap 400               on the hook for any resulting capital gains.
ETF Trust (MDY), which currently costs $361/share (see               Finally, the unavoidable truth is that no matter how
Figure 1).                                                       small a slice of a share is offered, it still may not be pre-
    Therefore, fractional trading of ETFs would not only         cise enough for some investors’ needs. For example,
allow sophisticated investors to more precisely replicate        1/10,000th of one share of MDY is about $0.04, mean-
ETF model portfolios, but it would also allow investors          ing an investor who wants to trade in chunks smaller than
with smaller asset bases to start building broadly diversi-      that will have to accept some rounding error, however
fied portfolios.                                                 small it may be.
    Fractional ETF trading can also improve the efficiency
of tax-loss harvesting, while avoiding the cash drag on          USE ETFs IN 401(k)s?
returns introduced by the remainder of an investor’s             These risks aside, partial-share ETF trading opens up
assets that cannot be invested in whole shares.                  investment to the lowest-asset-base investors, encourag-
                                                                 ing market participation at younger ages.
SOME FRACTIONAL ETF TRADING AVAILABLE                                 It also makes it easy to regularly invest small amounts
Some brokerages already allow for partial-share owner-           of cash, i.e., dollar cost averaging—such as that done
ship of ETFs by inserting themselves as a sort of middle-        through biweekly paycheck contributions. Therefore, if
man: They bundle all the necessary trades across their           and when brokerages like Schwab decide to offer frac-
various client accounts, then they buy and sell in lots of       tional ETF trading, it could dramatically improve the
whole ETF shares, as needed. Those shares are then put           attractiveness of using ETFs in employer-offered 401(k)
in a collective trust, shares of which can then be redistrib-    plans, for example.
uted to their clients on a fractional basis.                          However, trading commissions could still chip away at
     M1 Finance, for example, allows investors to invest in      the utility of fractional ETF trading in 401(k)s, given that
fractional amounts of ETFs as granular as 1/10,000th of a        in some or many cases, a $4.95 or $9.95 buy/sell cost sig-
share. Other independent brokerages, like Stockpile and          nificantly outstrips the price of the underlying fractional
Social Finance, also allow fractional ETF trading, as well as    ETF share. Yet the industry appears to be shifting more
some robo advisors like Betterment.                              and more to commission-free trading; in recent months,
     In addition, in November, J.P. Morgan quietly rolled out    Interactive Brokers, TD Ameritrade, E*Trade and Schwab
fractional ETF trading for some users of its You Invest robo     have dropped commissions on all trades.
platform, making the service available to accounts with               That said, the real solution to the aforementioned
less than $5,000 in ETFs and cash.                               problems of cash drag and imprecise investment alloca-
                                                                 tions might not be fractional ETF trading at all, but the
FRACTIONAL ETF TRADING RISKS                                     de-bundling of securities from the ETF packaging entirely,
Allowing fractional ETF trading requires a certain amount        through direct indexing.
of scale, however, while also introducing some risks.                 Via fractional stock ownership, direct indexing allows
Since the firm must trade in whole lots, it will assume          investors to precisely allocate their cash to the securities
some risk in owning the “leftover” fractions of ETFs—            of an index, without the use of any pooled investment
though if the brokerage trades in enough bulk, that risk         vehicle. Until recently, direct indexing was only available
may be small.                                                    to the highest-asset investors. But newer services, such as
    Furthermore, there’s a cost to managing the trust into       Orion, bring this technique to advisors and investors with
which the whole ETF shares are placed. Usually it’s only         lower and lower asset bases.
on the order of a few basis points, but that can add some             If direct indexing takes off in retirement accounts,
cash drag.                                                       fractional ETF trading may indeed become a true holy
    In addition, since fractional trading is tied to a collec-   grail: a once-prized treasure that everybody’s given up
tive trust managed by the brokerage, generally it can’t be       seeking.

                                                                                                                      JANUARY 2020   13
14   ETF.com/ETF Report
JANUARY 2020   15
ETF UNIVERSITY                                                                                                                              Compiled by ETF.com Staff

                                                                                 WHAT ABOUT ETFs?
                                                                                 All that’s great, but you want to learn about ETFs.

           What Is
                                                                                      So what is an ETF? Well, it’s a mutual fund too. It’s a pooled
                                                                                 investment vehicle that offers diversified exposure to a particular
                                                                                 area of the market. It can invest in stocks, bonds, commodities,
                                                                                 currencies, options or a blend of assets. Investors buy shares,
                                                                                 which represent a proportional interest in the pooled assets.
                                                                                      It’s a mutual fund in every aspect … except one.
                                                                                      And that’s a big one, which is hinted at in its very name:

           an ETF?
                                                                                 exchange-traded funds.

                                                                                 BEING EXCHANGE-TRADED
                                                                                 You buy shares in an ETF directly from any brokerage account.
                                                                                 Just like you buy shares in a stock, you can enter a buy order
                                                                                 in your Schwab or Fidelity account and buy any ETF you want.
                                                                                      You can also do it whenever you want. Whereas orders to
                                                                                 buy or sell a traditional mutual fund can be processed only once
                                                                                 per day (after the close of trading), ETF trades can take place
                                                                                 any time the market is open. You can buy shares in the morning
                                                                                 and sell them in the afternoon. You can buy them at 10 a.m.,
             Offering low-cost access to virtually every corner
                                                                                 sell them at 11 a.m. and buy them again after lunch if you want.
             of the market, ETFs allow investors big and small
                                                                                      You can also perform all sorts of stocklike strategies with
             to build institutional-caliber portfolios with lower
                                                                                 ETFs that you never could with mutual funds: selling short,
             costs and better transparency than ever before.
                                                                                 placing stop-loss or limit orders, even buying on margin.
                 But what exactly is an ETF? And how does it
                                                                                      And that’s just the beginning: The fact that ETFs are
             provide these benefits?
                                                                                 “exchange-traded” creates a series of other benefits that, accord-
                                                                                 ing to many market observers, make them a better overall choice
                                                                                 than traditional mutual funds for many reasons: lower costs, bet-
             To understand how ETFs work, the best place to start is with
                                                                                 ter tax efficiency and more. Of course, in other situations, they
             something familiar, like a traditional mutual fund.
                                                                                 can be worse: commissions, trading spreads and other risks.
                  Imagine half a dozen investors, sitting at home, each try-
                                                                                      In sum, an ETF is a tool that allows investors to access
             ing to figure out the best way to invest in the stock market.
                                                                                 different corners of the market—everything from U.K. equi-
             They could each go out and buy a few stocks on their own,
                                                                                 ties to Chinese tech stocks to high-yield bonds, spot gold
             but who has the time or resources to manage a portfolio of
                                                                                 bullion and more—at low costs, from the comfort of a tradi-
             50 or 100 stocks?
                                                                                 tional brokerage account.
                  Instead, they decide to band together. They pool all of
                                                                                      It’s like a mutual fund 2.0.
             their money and hire a professional investment manager to
             invest it for them.
                  To keep track of who invested what, each investor receives
             “shares,” representing their stake in the total investment.       LARGEST ETFs BY AUM
                  Because it’s your money, you want to know how much            TICKER                        FUND                  ER              AUM
             your investment is worth … every day. So every day, the             SPY SPDR S&P 500 ETF Trust                        0.09%          $279.75B
             mutual fund tallies up the value of everything it owns and
                                                                                 IVV     iShares Core S&P 500 ETF                  0.04%          $196.23B
             divides it by the number of shares that exist. Presto whammo:
                                                                                 VTI     Vanguard Total Stock Market ETF           0.03%           $131.99B
             You know exactly what each share is worth.
                  If you want to buy more shares, you know the amount            VOO Vanguard S&P 500 ETF                          0.03%          $125.69B
             of cash to send the mutual fund for each share. If you want         QQQ Invesco QQQ Trust                             0.20%           $83.20B
             to sell shares, you know exactly how much cash to expect
                                                                                 VEA Vanguard FTSE Developed Markets ETF           0.05%           $75.96B
             in return.
                  It’s an elegant system, and mutual funds have existed          IEFA iShares Core MSCI EAFE ETF                   0.07%           $70.82B

             for close to 100 years. They currently provide exposure to          AGG iShares Core U.S. Aggregate Bond ETF          0.05%           $66.17B
             stocks, bonds, commodities and other assets.                        VWO Vanguard FTSE Emerging Markets ETF            0.12%           $63.49B

                                                                                 EFA iShares MSCI EAFE ETF                         0.31%           $61.94B

                                                                                                                            Source: FactSet; data as of 11/20/2019
     16   ETF.com/ETF Report

                                                                    LARGEST ETNs BY AUM
Investors typically use the term “ETF” to mean
                                                                     TICKER                           ETN                             EXP RATIO      AUM
a lot of things that aren’t technically “exchange-
traded funds,” a roster that includes the exchange-                   AMJ JPMorgan Alerian MLP Index ETN                               0.85%        $2.45B
traded note (ETN), which is the most important of                     FLGE Credit Suisse FI Large Cap Growth Enhanced ETN               1.52%       $1.82B
these additional structures.                                          FIHD UBS AG FI Enhanced Global High Yield ETN                     1.65%       $1.80B
     ETNs are debt notes issued by a bank. When you buy an            FBGX UBS AG FI Enhanced Large Cap Growth ETN                      1.29%       $1.33B
ETN, the bank promises to pay you a certain pattern of return.
                                                                      FIYY Barclays ETN+ FI Enhanced Global High Yield ETN Series B    0.93%        $1.21B
If you buy an ETN linked to the price of gold, for instance, the
                                                                      FRLG Large Cap Growth Index-Linked ETN                            1.46%       $1.20B
value of that ETN will increase if the gold price goes up.
     The beauty of the ETN structure is that it can be linked to      VXX iPath Series B S&P 500 VIX Short Term Futures ETN            0.89%        $1.01B
anything. There are ETNs that track commodities, and ETNs             UGAZ VelocityShares 3X Long Natural Gas ETN                       1.65%     $910.38M
that track hard-to-reach corners of the equity market. They           TVIX VelocityShares Daily 2x VIX Short-Term ETN                   1.65%     $894.14M
sometimes combine stock or bond positions with options
                                                                      MLPI ETRACS Alerian MLP Infrastructure Index ETN                 0.85%      $889.10M
overlays, or use other sophisticated strategies that would be
difficult to package into a traditional ETF. In the commodity
                                                                                                                         Source: FactSet; data as of 11/20/2019
space, the ETN also offers significant long-term tax advan-
tages compared with most ETFs.
     The downside of an ETN is that if the underlying bank
goes bankrupt, you lose essentially all of your money. There
were, for instance, a few ETNs backed by Lehman Brothers.
While most investors in Lehman’s ETNs fled before the firm
shut down, anyone who held to the bitter end probably still
has a bad taste in their mouth.
     The good news is that this credit risk in most situations is

                                                                         What Is
minor. Institutional investors can “redeem” (get their money
back) from the underwriter of ETN daily. While anything can
happen, you usually see major bank defaults coming more
than a day or two ahead.
     The even-better news is credit risk is easily monitored.
FactSet monitors and reports on the credit risk of every ETN

                                                                         an ETN?
daily, and the data appears on the ETF.com website. The data
provider does that by watching the cost of credit default
swaps (CDS) on the underwriting banks each day. CDS are
like insurance—investors buy them to protect themselves
against a company’s default—so they are the best possible
view of the likelihood a bank will go down.
     How do you check? Just pull up the Efficiency Tab on any
ETN (e.g., www.etf.com/AMJ) and check out the ETN Coun-
terparty Risk measure. If it says “Low,” you’re OK. If it says
“High,” run for the hills.

                                                                                                                                             JANUARY 2020         17

                                                                                    ETF issuers each day publish the lists of what securities
                                                                                an authorized participant (AP) must deliver to the ETF to cre-
                                                                                ate new shares (“creation baskets”), as well as what shares
                                                                                they’ll get if they redeem shares from the ETF (“redemption

                                                                                baskets”). This—combined with the ability to see the full
                                                                                holdings of the index an ETF is aiming to track—provides an
                                                                                extremely high level of disclosure even for those few ETFs
                                                                                that fall short of the daily-disclosure ideal.

                                                                                GREATER TAX EFFICIENCY

            Are ETFs
                                                                                ETFs are vastly more tax efficient than competing mutual funds.
                                                                                    If a mutual fund or ETF holds securities that have appreci-
                                                                                ated in value, and sells them for any reason, they will create a
                                                                                capital gain. These sales can result either from the fund sell-
                                                                                ing securities for a tactical move, due to a rebalancing effort,
                                                                                or to meet redemptions from shareholders. By law, if funds

              So Tax
                                                                                accrue capital gains, they must pay them out to shareholders
                                                                                at the end of each year.
                                                                                    Generally, ETFs do much better than actively managed
                                                                                mutual funds.
                                                                                    Why? For starters, because they’re index funds, most
                                                                                ETFs have very little turnover, and thus amass far fewer

                                                                                capital gains than an actively managed mutual fund would.
                                                                                But they’re also more tax efficient than index mutual funds,
                                                                                thanks to the magic of how new ETF shares are created and
                                                                                    When a mutual fund investor asks for her money
                                                                                back, the mutual fund must sell securities to raise cash
                                                                                to meet that redemption. But when an individual investor
                                                                                wants to sell an ETF, he simply sells it to another investor

                  wo of the great, underappreciated advantages                  like a stock. No muss, no fuss, no capital gains transaction
                  of ETFs are their transparency and tax                        for the ETF.
                  efficiency. Compared with mutual funds, ETFs                      And when an AP redeems shares of an ETF with an issuer,
                  are light years ahead in these two critical                   it actually gets even better. When APs redeem shares, the
             categories.                                                        ETF issuer doesn’t typically rush out to sell stocks to pay the
                                                                                AP in cash. Rather, the issuer simply pays the AP “in kind”—
             BETTER TRANSPARENCY                                                delivering the underlying holdings of the ETF itself. No sale
             One of the key benefits of ETFs is that they offer better          means no capital gains.
             transparency into their holdings than competing mutual                 The ETF issuer can even pick and choose which shares to
             funds. The ability to verify your positions on a daily basis (in   give to the AP—meaning the issuer can hand off the shares
             most cases) is a big plus.                                         with the lowest possible tax basis. This leaves the ETF issuer
                 By law and by custom, mutual funds are only required           with only shares purchased at or even above the current mar-
             to disclose their portfolios on a quarterly basis—and then         ket price, thus reducing the fund’s tax burden and ultimately
             only with a 30-day lag. Mutual funds can and do stray from         resulting in higher after-tax returns for investors.
             their described targets—a phenomenon known as “style                   The system doesn’t work so smoothly for all ETFs. Fixed-
             drift”—which can negatively impact an investor’s asset             income ETFs, which have more turnover and often have cash-
             allocation plan. In short, when you buy a mutual fund,             based creations and redemptions, are less tax efficient than
             you’re taking a leap of faith—and in the past, investors           their equity brethren.
             have been burned.                                                      But all else equal, ETFs win hands-down, with two
                 ETFs are far more transparent. By custom, most—but not         decades of history showing they have the best tax efficiency
             all—ETFs disclose their full portfolios on public, free web-       of any fund structure in the business.
             sites every day of the year.

     18   ETF.com/ETF Report

     he key to understanding how ETFs work is                       remove money from the fund.
     the “creation/redemption” mechanism. It’s                          With ETFs, APs do most of the buying and selling. The
     how ETFs gain exposure to the market, and is                   AP pays all the trading costs and fees, and even pays an
     the “secret sauce” that allows ETFs to be less                 additional fee to the ETF provider to cover the paperwork
expensive, more transparent and more tax efficient                  involved in processing all the creation/redemption activity.
than traditional mutual funds.                                          The beauty of the system is that the fund is shielded
   It’s a bit complicated, but worth understanding.                 from these costs. Funds may still pay trading fees if they
                                                                    have portfolio turnover due to index changes or rebalances,
WHY IT’S IMPORTANT                                                  but the fee for putting new money to work (or redeeming
The creation/redemption process is important for ETFs in a          money from the fund) is typically paid by the AP. (Ultimately,
number of ways. For one, it’s what keeps ETF share prices           investors entering or exiting the ETF pay these costs through
trading in line with the fund’s underlying NAV.                     the bid/ask spread.)
     Because an ETF trades like a stock, its price will fluctuate       The system is inherently more fair than the way mutual
during the trading day, due to simple supply and demand. If         funds operate. In mutual funds, existing shareholders pay
many investors want to buy an ETF, for instance, the ETF’s          the price when new investors put money to work in a fund or
share price might rise above the value of its underlying            departing investors sell their shares, because the fund bears
securities.                                                         the trading expense. In ETFs, those costs are borne by the
     When this happens, the authorized participant can jump         AP (and later by the individual investor looking to enter or
in to intervene. Recognizing the “overpriced” ETF, the AP           exit the fund).
might buy up the underlying shares that compose the ETF
and then sell ETF shares on the open market. This should
help drive the ETF’s share price back toward fair value, while

                                                                      What Is the
the AP earns a basically risk-free arbitrage profit.
     Likewise, if the ETF starts trading at a discount to the
securities it holds, the AP can snap up 50,000 shares of that
ETF on the cheap and redeem them for the underlying secu-
rities, which can be resold. By buying up the undervalued

ETF shares, the AP drives the price of the ETF back toward
fair value while once again making a nice profit.
     This arbitrage process helps to keep an ETF’s price in line
with the value of its underlying portfolio. With multiple APs
watching most ETFs, ETF prices typically stay in line with the

value of their underlying securities.
     This is one of the critical ways in which ETFs differ from
closed-end funds. With closed-end funds, no one can cre-
ate or redeem shares. That’s why you often see closed-end
funds trading at massive premiums or discounts to their

NAV: There’s no arbitrage mechanism available to keep sup-
ply and demand pressures in check.
     The ETF arbitrage process doesn’t work perfectly, and it
pays to make sure your ETF is trading at fair value. But most
of the time, the process works well.

The other key benefit of the creation/redemption mecha-
nism is that it’s an extraordinarily efficient and fair way for
funds to acquire new securities.
    As discussed, when investors pour new money into
mutual funds, the fund company must take that money and
go into the market to buy securities. Along the way, they pay
trading spreads and commissions, which ultimately harm
returns of the fund. The same thing happens when investors

                                                                                                                       JANUARY 2020   19

                                                                        market demand, it turns to an AP, which may be a market
                                                                        maker, a specialist or any other large financial institution.
                                                                        Essentially, it’s someone with a lot of buying power.
                                                                            It is the AP’s job to acquire the securities that the ETF
                                                                        wants to hold. For instance, if an ETF is designed to track the
                                                                        S&P 500 Index, the AP will buy shares in all the S&P 500
                                                                        constituents in the exact same weights as the index, then
                                                                        deliver those shares to the ETF provider. In exchange, the pro-
                                                                        vider gives the AP a block of equally valued ETF shares, called
                                                                        a creation unit. These units are usually formed in blocks of
                                                                            The exchange takes place on a one-for-one, fair-value
                                                                        basis. The AP delivers a certain amount of underlying securi-
                                                                        ties and receives the exact same value in ETF shares, priced
                                                                        based on their net asset value (NAV), not the market value at
                                                                        which the ETF happens to be trading.
                                                                            Both parties benefit from the transaction: The ETF pro-
                                                                        vider gets the stocks it needs to track the index, and the AP
                                                                        gets plenty of ETF shares to resell for profit.
                                                                            The process can also work in reverse. APs can remove
                                                                        ETF shares from the market by purchasing enough of those
                                                                        shares to form a creation unit and then delivering those
                                                                        shares to the ETF issuer. In exchange, APs receive the same

     What Are
                                                                        value in the underlying securities of the fund.

                                                                        HOW DO APs GAIN THE RIGHT TO CHANGE
                                                                        THE SUPPLY OF ETP SHARES?
                                                                        ETP issuers decide. Prior to launch, the issuer will designate

                                                                        one or more AP to the fund. More can sign up over time. The
                                                                        most popular ETFs will have dozens of APs.

                                                                        HOW DO APs IMPACT LIQUIDITY?
                                                                        An AP’s ability to create and redeem shares helps keep ETFs

                                                                        priced at fair value.
                                                                            For example, if demand for an ETF increases and a pre-
                                                                        mium develops, APs step in to create more shares and push
                                                                        the ETF’s price back in line with its actual value. If there’s a
                                                                        rush to sell and a discount develops, APs buy ETF shares on
                                                                        the open market and redeem them with the ETF issuers to
                                                                        reduce supply.
                                                                            Generally, the greater the number of APs for a particular

                   uthorized participants (APs) are one of              ETF, the better: The force of competition is more likely to keep
                   the major parties at the center of the ETF           the ETF trading close to its fair value.
                   creation/redemption mechanism, and as such,              The task set forth for an AP is not necessarily an easy
                   they play a critical role in ETF liquidity. In       one: Sometimes the underlying market that they must
             essence, APs are ETF liquidity providers that have         access to change the supply of ETF shares is illiquid, or
             the exclusive right to change the supply of ETF            just difficult to access. An exchange-traded product track-
             shares on the market.                                      ing the S&P 500 will be easy to access and easily hedge-
                                                                        able for most APs, while one tracking, e.g., Nigeria equi-
             ROLE OF AUTHORIZED PARTICIPANTS                            ties will be tough.
             When an ETF company wants to create new shares of its          Mostly, APs are invisible to individual investors and advi-
             fund, whether to launch a new product or meet increasing   sors. Still, it’s good to know they’re there.

     20   ETF.com/ETF Report

       onfusing as it seems, ETFs have more than one             not always possible.
       “price.”                                                      Sometimes access is just a time challenge: For ETFs hold-
           First, there’s its actual value, which is             ing international securities, there could be a delay before the
       measured by net asset value (NAV) at the                  AP is finally able to access the underlying market and effec-
end of each day and by intraday NAV (iNAV) in the                tively create or redeem ETF shares—the delay can lead to
middle of the day.                                               temporary premiums and discounts.
    However, because ETFs trade on an exchange,                      Other times, restricted access to the underlying securi-
they also have a current market price—which could                ties could be symptomatic of more serious structural prob-
be more or less than its actual value.                           lems. Depending on the severity, the issuer may even have to
    In short, if the price of the ETF is trading                 halt the creation of new ETF shares.
above its NAV, the ETF is said to be trading at a                    During the Arab Spring of 2010, for instance, ETFs track-
“premium.” Conversely, if the price of the ETF is                ing the Egyptian markets shuttered, leading to wild swings
trading below its NAV, the ETF is said to be trading             in the perceived premiums of those ETFs. In these cases,
at a “discount.”                                                 the ETF effectively starts trading like a closed-end fund, and
    In relatively calm markets, ETF prices and NAV               can trade at constant premiums until creations are resumed,
are generally close. However, when financial markets             when such premiums usually vanish.
become more volatile, ETFs quickly reflect changes                   The important thing to remember is that ETFs gener-
in market sentiment, while NAV may take longer to                ally trade close to their fair value, and premiums or dis-
adjust—resulting in premiums and discounts.                      counts tend to be short-lived. However, that’s not always
                                                                 the case, so dig deeper before snapping up a fund simply
WHY?                                                             because it’s trading at a discount (you may have to sell
This can happen throughout the trading day, because the          at a bigger discount). Lastly, use limit orders set close to
ETF and its underlying securities are actually two distinct      NAV to prevent buying at a large premium or selling at a
liquidity pools that are only loosely linked.                    large discount.
     If optimistic investors start aggressively bidding up an
ETF—more so than its underlying securities—the price of
the ETF may rise faster than the price of its underlying secu-

rities and, consequently, may trade at a premium.
     Similarly, if pessimistic investors aggressively sell an
ETF—more so than its underlying securities—the ETF may
trade at a discount. (Imagine a sumo wrestler escaping
through a small window.)

                                                                  Premiums &
     Alternatively, premiums or discounts may arise because
the ETF and its underlying securities trade on exchanges
that are in different time zones.
     Consider the scenario of ETFs listed on the NYSE that
track European indexes. It’s not uncommon for those ETFs

to trade significant volume after, say, the London Stock
Exchange closes at 11:30 a.m. ET. The price of these ETFs will
reflect real-time changes in market sentiment, while NAV
will be based on stale prices from the earlier LSE close.
     In this case, any significant deviation between ETF price
and NAV will likely vanish when both exchanges are open at
the same time.

Thanks to the creation/redemption mechanism, deviations
between ETF price and its NAV tend to be short-lived.
    That said, not all premiums and discounts quickly self-
correct; some persist for a variety of reasons. For an autho-
rized participant (AP) to create or redeem shares quickly, he
or she needs access to the underlying securities—which is

                                                                                                                     JANUARY 2020   21

                                                                               instances where the process wasn’t smooth, but generally
                                                                               it’s better to have a liquidation rather than a delisting.
                                                                                    When an ETF delists without liquidating its portfolio,
                                                                               investors who fail to sell their shares before the last trading
                                                                               date will be forced to trade over the counter—a significantly
                                                                               less liquid, more cumbersome and generally more expensive

                                                                               process than trading on an exchange.

                                                                               DOWNSIDE OF CLOSURES
                                                                               Even if a closure goes smoothly, it can still be hugely inconve-
                                                                               nient, for a few reasons.

        & Avoiding
                                                                                    From the perspective of advisors, avoiding funds at high
                                                                               risk of closure can help avoid egg-on-your-face phone calls to
                                                                               clients after recommending a fund that’s now closing.
                                                                                    Further, when an ETF delists or liquidates, it creates rein-
                                                                               vestment risk for its investors—not to mention the extra and
                                                                               unnecessary burden associated with reinvesting. Once you

     ETF Closures
                                                                               receive your cash-equivalent NAV, you’ve got to find some-
                                                                               where else to put it, which could mean repeating the entire
                                                                               process that landed you in the ETF to begin with.
                                                                                    Finally, since investors must either sell their shares or
                                                                               receive cash equivalents of NAV, they’re forced to realize any
                                                                               capital gains. That can mean an unanticipated tax burden.

                  ike any business, even low-cost ETFs need                    CLOSURE RISK FACTORS
                  to generate revenue to cover their costs.                    It’s relatively easy to predict likely candidates for closing, and
                  However, plenty of ETFs fail to garner the                   a little homework can be good insurance.
                  assets necessary to cover these costs and,                         Low AUM is one of the best indicators of closure risk. After
             consequently, ETF closures happen regularly. In                   all, funds with hundreds of millions of dollars in assets under
             fact, a significant percentage of ETFs are currently              management are too profitable to close. So, $50 million is
             at risk of closure.                                               generally the threshold after which a fund is unlikely to close.
                 There’s no need to panic though: Broadly                      That said, there are hundreds of ETFs with low AUM that don’t
             speaking, ETF investors don’t lose their investment               close each year—and some of them are great products.
             when an ETF closes, but the situation can be                            Surprisingly, even more important than AUM in predicting
             inconvenient and costly.                                          fund closure is the strength of its issuer. After all, when the
                                                                               issuing company is unprofitable, all of its businesses are at risk.
             WHAT HAPPENS WHEN AN ETF CLOSES?                                        Consequently, when evaluating whether a low-AUM fund
             Once the decision to delist or liquidate an ETF has been          is at risk of closure, consider the strength of its issuer as well
             made, a prospectus supplement will state the ETF’s last trad-     as the issuer’s history.
             ing date and its liquidation date (if it has one).                      Finally, if a particular ETF is the least popular (by AUM)
                 At this point, or soon after, “business as usual” ceases,     among 10 ETFs that offer similar exposure, it’s more likely to
             and the fund halts creations as it prepares to convert to cash.   close than a similarly unpopular ETF that is the only ETF offer-
             This causes ETF performance to diverge from the perfor-           ing exposure to a particular sector/country/strategy. Essen-
             mance of its underlying index.                                    tially, unpopular funds in oversaturated markets are at greater
                 It’s generally advisable to sell any remaining shares you     closure risk than unpopular funds offering unique exposure.
             may be holding before the last day of trading.
                                                                               IN SUM
             DELISTING VS. LIQUIDATION                                         Ultimately, don’t let media headlines about ETF closures
             When an ETF liquidates, investors generally receive cash          invoke fear, because first and foremost, ETF investors usually
             distributions equal to NAV, so even if you fall asleep at the     don’t stand to lose when an ETF closes. Secondly, funds at
             wheel, you will receive the fair value of your shares—most        risk of closure are largely easy to identify, which is to say that
             of the time. It’s worth noting that there have been rare          it should be easy for you to avoid the high-risk funds.

     22   ETF.com/ETF Report

      ecurities lending is a fairly simple process that           none of their underlying holdings paid dividends. In these
      can generate extra returns for ETF investors, but           cases, the ETF generated sufficient revenues from securities
      it also introduces extra risk—however minimal.              lending alone to enable a hefty dividend for its investors.
           The logic behind securities lending is this: An             Let’s keep things in perspective though; most ETFs
equity ETF will typically hold thousands of shares of             don’t earn such lofty premiums for lending their securities.
various stocks. If there’s a short-seller out there who           While they certainly provide a tail wind for ETFs, the effect
wants to borrow those stocks—and agrees to post                   of securities-lending revenue is usually relatively muted and
collateral and pay the ETF a fee for doing so—why not             generally serves to offset expenses rather than generate sig-
lend them out and make a little extra dough?                      nificant outperformance.
    Generally speaking, securities-lending activities                  It’s worth noting that, rather than distributing securities-
are positives for shareholders and contribute to tighter          lending revenue as dividends, the usual course of business is
index tracking and better overall returns. They’re not            for ETFs to invest the extra revenue in its portfolio holdings.
without some risks; while we believe they’re generally            In this case, investors reap the rewards via fund performance
minor, they’re nonetheless worth considering.                     rather than dividend payments.
                                                                       The takeaway is that securities lending introduces some
RISKS OF SECURITIES LENDING                                       risk to ETF portfolios—much of which has been mitigated by
You’d think the biggest risk in securities lending is that the    issuer policies. Meanwhile, the benefits of securities lending
short-seller you lent shares to goes bankrupt. Fortunately,       range from negligible to highly significant.
industry practice is for borrowers to provide collateral
exceeding the value of the loaned securities by a set margin.

So while a busted counterparty is a pain, it’s not immedi-
ately costly.
    The costs come in if the borrower is a short-seller (it
usually is) and the security that they shorted rallies strongly
in a single day, the borrower defaults and the provided col-

lateral is insufficient to cover the cost of reacquiring the
security. Remember, collateral balances are only settled (at
best) daily.


The real risk with securities lending is that when ETF issu-
ers receive cash collateral, they don’t just sit on it—they
put it into money market securities to earn some small
amount of interest on the cash. Where firms get into trou-
ble is when these collateral investments go bankrupt, such
as when Lehman Brothers went under. It’s unlikely, but it’s

It depends. Just as prices in the rest of the economy are sub-
ject to the forces of supply and demand, so too are securi-
ties-lending premiums.
    Securities that are in high demand in the loan mar-
ket command higher premiums. ETFs that hold these in-
demand securities can earn a significant premium lending
out portfolio holdings. Premiums tend to fluctuate as certain
sectors, markets or countries fall in and out of favor with
    When these factors align perfectly, ETFs can earn huge
premiums for lending securities. Historically, some ETFs
(those in solar in 2017, for instance) have paid dividends
amounting to a yield as high as 5-7%, despite the fact that

                                                                                                                        JANUARY 2020   23

                                                                                     But if you wanted to buy MSFT right now, you’d probably
                                                                                have to pay $50.10. If you wanted to sell right now, all you’d
                                                                                get is $49.90. Those are the prices you’d get if you enter a
                                                                                market order into your brokerage window.
                                                                                     The wider the spread, the more it will cost you to trade MSFT.
                                                                                     Bid/ask spreads are so important to ETP trading because,
                                                                                unlike a mutual fund—which you buy and sell at net asset

                                                                                value—all ETFs trade like single stocks, so ETFs trade with
                                                                                bid/ask spreads. That’s the price of the “exchange-traded”
                                                                                in the name.
                                                                                     Spreads widen and narrow for various reasons. If the
                                                                                ETF is popular and trades with robust volume, then bid/ask

                                                                                spreads tend to be narrower. But if the ETF is thinly traded, or
                                                                                if the underlying securities of the fund are highly illiquid, that
                                                                                can also lead to wider spreads.
                                                                                     Overall, the narrower the bid/ask spread, the lower the
                                                                                cost to trade.

   & Volume
                                                                                VOLUME & MARKET IMPACT
                                                                                However, when trading stocks or ETFs, you also have to look
                                                                                at volume and so-called market impact.
                                                                                     Volume is the number of shares that trade on any given day.
                                                                                The higher the volume, the better. For example, if MSFT trades,
                                                                                on average, 10 million shares per day, it’ll be easier to trade than
                                                                                something that trades 100 shares per day. Note, however, that

                   TFs trade like stocks. ETFs trade nothing at all             spreads could be tight on both, which could mislead unwitting
                   like stocks. Both of these statements are true.              investors to conclude that both securities are equally liquid.
                   But to trade ETFs, you should know why this                       Typically, the number of shares offered on the “bid” or
                   is so.                                                       the “ask” will be small—sometimes 100 shares, sometimes
                                                                                more, but rarely a huge amount. If you try to buy 10,000
             BID/ASK SPREAD                                                     shares of something that only trades 100 shares per day, you
             The place to start with understanding how ETFs trade is to         could have trouble.
             understand how individual stocks trade.                                 To go back to our MSFT example, someone might be
                 At any given time, there are two prices for any com-           willing to sell you 100 shares of MSFT at $50.10, but if you
             mon stock: the price at which someone is willing to buy that       want to buy 10,000 shares, you might have to pay $50.25 or
             stock (the “bid”) and the price at which someone is willing        more. The amount that you drive up the price of something
             to sell (the “ask”). The difference between these two prices       you’re trying to buy is called the “market impact.”
             is called the “spread.”
                 The reason spreads exist is because, in any open market,       HOW DOES THAT IMPACT ETF TRADING
             folks try to negotiate the best prices they can get. If you’re     & HOW ARE ETFs DIFFERENT?
             looking to buy, you’ll naturally want to see if someone is will-   Because ETFs trade on exchanges like stocks, they have bid/
             ing to sell for less than the last traded price.                   ask spreads, volumes and potential market impact, too. All
                 Conversely, if you’re selling, you’ll naturally hope that      else equal, you’ll do better trading something that has high
             someone will be willing to buy it for more than the last           volume and a tight bid/ask spread. In this way, trading ETFs
             quoted price. Spreads are simply the result of buyers and          is just like trading a stock.
             sellers negotiating on prices.                                          But ETFs have a critical difference that dramatically
                 For example, let’s imagine Microsoft’s stock is trading        alters the playing field for investors.
             with the bid at $49.90 and the offer at $50.10. The spread              With single stocks, there’s no way to create new shares.
             is therefore $0.20. If someone asked you what a share of           But institutional investors called authorized participants
             MSFT was “worth,” you’d probably choose the midpoint:              (APs) are allowed to create new shares of an ETF to meet
             $50.00, or maybe the last price at which you can see a trade       demand. So if you want to buy a lot of an ETF … say, 50,000
             actually happened.                                                 shares … an AP might create those shares to fill your order.

     24   ETF.com/ETF Report
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