Conceptual differences between ETFs and conventional open-end inde

The first and the most important difference between ETFs and conventional open- end index funds is that ETFs are traded in the secondary market at the price prevailing at that moment, and not at NAV. ETFs can be purchased or sold at any time during a

trading day unlike conventional mutual funds, the shares of which can be exchanged directly with the funds only at the 4 pm NAV as determined by the funds. This option of intraday trading may not necessarily be valuable to every investor; however, it may appeal to investors who are concerned about the ability to get out of a position before the market is closed when prices are volatile.

Primary market transactions in ETFs consist of in-kind creations and redemptions in large sizes. This is another important characteristic of the organizational structure of ETFs that distinguishes them from conventional funds. The ability to trade like stocks in the secondary market makes ETFs similar to closed-end mutual funds, but the feature of in-kind creations and redemptions makes ETFs very distinct from all other types of managed portfolios. This also allows ETF managers to deal with the problem of premiums and discounts due to divergence between price and NAV. The possibility of intraday creations or redemptions is a significant factor in maintaining ETF prices extremely close to NAV.

Also, redemption-in-kind can improve the tax efficiency of ETFs, which is important for the majority of investors. In contrast, most redemptions of conventional funds are for cash, and, in the case of significant fund holder redemptions, a fund is required to sell shares of the portfolio that may have appreciated from their original

cost.23 This procedure can realize capital gains, which have to be distributed to all

shareholders, and even continuing investors have to pay taxes on these distributions. ETFs, however, take advantage of a special tax treatment through redemption-in-kind, thus improving their tax efficiency. In such a scenario, the low cost basis shares of each

23 _{Redemption-in-kind in conventional funds is allowed on large amounts with a minimum of $250,000;} however, funds are reluctant to do so. In addition, the majority of investors have positions smaller than the specified minimum.

stock in an ETF’s portfolio are delivered against redemption requests. Conventional funds, in contrast, try to sell their highest cost basis stocks first, leaving the cost basis of the portfolios low and, therefore, making funds subject to higher capital gains later, e.g. in case a particular stock leaves the index and the portfolio needs rebalancing. With ETF in-kind redemptions, a fund portfolio has a relatively higher cost basis, which means that acquired stocks generate smaller gains when they leave the index. There are two types of capital gain tax liabilities: when investors sell fund shares (controlled by the investors), and for funds’ activities independent of investor trading (not controlled by the investors). ETFs create tax efficiency for the latter type, making ETFs more attractive for tax sensitive investors.

Since ETFs are traded just like any stock, ETFs and conventional funds also differ in distribution channels, which is another important factor. The shares of an ETF must be purchased through brokerage firms, which entail commission costs, such as brokerage fees and a bid-ask spread. In contrast, conventional fund’s shares can be purchased directly from the fund. Therefore, shareholder accounting for ETFs takes place at brokerage firms rather than at the funds. Elimination of the individual shareholder

transfer agency function reduces operating costs.24 The expenses of ETFs tend to reflect

the cost savings on this function (see data description in Table 3). However, even if operating costs are reduced, an individual investor may face different marginal costs when investing through ETFs due to brokerage fees, commissions, and bid-ask spreads. Thus, depending on the investor’s trading activity and the volume of trade, the costs and,

therefore, preferences of investing through an ETF versus a conventional fund can differ among types of investors.

In addition, ETFs can be purchased on margin and sold short, and some ETFs have traded options, which are not available for conventional mutual funds. These features can be important for investors who perform risk management, and may be especially useful for institutional investors who are looking to hedge large-sized contracts. In this case, ETFs are attractive because they have a large variety in tracked indexes, and, unlike futures contracts, they do not expire.

On the other hand, ETFs and conventional index funds have many similarities. Both have operating expenses, which reduce investors’ returns. Most ETFs to date have been designed to track a specific market index, similar to the way conventional index funds do. Both ETFs and conventional index funds may experience tracking errors in matching pre-tax returns on their tracked indexes (Blume and Edelen (2003, 2004), Gastineau (2004), Elton et al (2002)).

However, even though ETFs and conventional index funds offer similar products, the differences listed above suggest that they may be preferred by different types of investors. ETFs may be preferred by intraday investors who demand short-term liquidity or immediacy in trade, by long-term investors who buy in large amounts and seek lower management fees, by hedgers and speculators because of options traded on ETFs that allow for minimizing exposure or maximizing profits through leverage, and by investors who are tax sensitive due to the tax-efficiency of ETFs. On the other hand, conventional index funds would be preferred by active investors who make many small purchases or

sales due to no commission costs, by those who place less value on liquidity or immediacy in trade, and by those who are tax exempt or less tax sensitive.