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What is a Closed-End ETF?
Like a traditional mutual fund, a Closed-End ETF is an investment company that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. However, unlike a mutual fund, a Closed-End ETF issues a fixed number of shares through an initial public offering, and lists those shares on a national stock exchange such as the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX). Investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund - rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock.
Is a Closed-End ETF closed to new investments?
No. Although Closed-End ETFs have a fixed number of shares outstanding, investors can purchase and sell shares in Closed-End ETFs at any time during the trading day, similar to any other listed stock.
How do I buy/sell Closed-End ETFs?
Like mutual funds and stocks, Closed-End ETFs may be purchased in regular brokerage accounts (individual or joint-name), retirement plan accounts, trust accounts or custodial accounts. Closed-End ETFs can be purchased and sold on national exchanges just like any other stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of Closed-End ETFs.
Is there a sales charge associated with purchasing shares?
No. Because Closed-End ETFs trade on national exchanges similar to stocks, there is no sales charge attributed to the transaction, although your broker will charge a commission for the stock purchase or sale.
How can I hold my Closed-End ETF?
Just like regular stocks, investors can hold Closed-End ETFs in book entry or in certificate form. If you hold the shares in book-entry, your broker maintains the records for the shares, and investors can transact in those shares without providing any paper certificates. In certificate form, a physical certificate is mailed to the investor, and any transactions associated with fund shares must be accompanied with the certificate.
What is a rights offering?
Although Closed-End ETFs have a fixed number of shares and assets outstanding, there are mechanisms that fund managers can use to raise additional capital. Fund management can raise additional capital by issuing shareholders rights to buy new common shares at predetermined prices. These offerings often involve substantial discounts to net asset value to encourage participation, which also dilutes common shareholder ownership in the fund.
What is an automatic dividend reinvestment plan?
Typically, shareholders can choose to receive any dividends distributed by the Closed-End ETF in cash, or use the dividends to purchase additional fund shares. An automatic dividend reinvestment plan automatically invests all dividends received by investors in additional fund shares (this is the default choice in some Closed-End ETFs).
What is the portfolio composition of these funds?
The specific securities that Closed-End ETFs hold is dependent on the portfolio manager and the investment objectives of the fund, and can range from a concentrated portfolio of just a few companies, to a diversified portfolio of several hundred companies.
What is leverage and how is it used?
All Closed-End ETFs issue common shares. Many funds also attempt to generate a higher level of income for their common shareholders through leverage. One method to implement leverage is for a fund to issue preferred stock that is designed to pay lower short-term rates to investors seeking short-term liquidity. The proceeds are used to buy generally longer-term investments. Common shareholders can earn extra income from the difference between the rates earned on the fund's long-term bond portfolio and the short-term rates paid to preferred shareholders.
Because of leverage, the net asset value per common share will be more volatile than those of comparable unleveraged funds, since the increases or decreases in the total portfolio value are all attributed to the common shares.
Can Closed-End ETFs go out of business?
Because Closed-End ETFs are set up as investment companies, they are prohibited from engaging in any activity that is not of an investment nature. The only real way for a Closed-End ETF to go out of business is for all the securities in its portfolio to become worthless.
Can an investor make money by buying funds selling at a discount?
Since there is no guarantee that funds trading at a discount will ever trade at their net asset value, there is no guarantee that the investor can make money by purchasing shares trading at a discount and hoping for that discount to disappear. Alternatively, there is no guarantee that funds trading at a premium will continue to trade at a premium. Investors that purchase funds trading at a premium may be subject to premium erosion, and even trading at a discount.
For specialized investments (such as specific industries or countries), wouldn't an open-end mutual fund offer greater diversification than a Closed-End ETF?
Although many mutual funds and Closed-End ETFs are managed in a similar manner during rational markets, Closed-End ETFs may offer an advantage during periods of market stress. Because Closed-End ETFs do not have to liquidate positions as shareholders redeem shares, Closed-End ETFs have the potential to ride out this period without adversely affecting the portfolio.
Are dividends paid on Closed-End ETFs?
Similar to traditional open-end mutual funds, Closed-End ETFs distribute their earnings to shareholders in two ways. First, income dividends from interest or stock dividends are passed through to shareholders, net of expenses. Second, realized capital gains (net of realized capital losses) distributions are passed through to shareholders (typically once a year in November or December).
However, several leveraged Closed-End ETFs also have managed distribution policies for their common shareholders. That is, the fund promises to distribute a fixed portion of their net asset value each year. A fund may institute this policy to differentiate itself from competitors and to attempt to narrow the gap between price and net asset value. However, fixed payout plans put pressure on fund managers to meet their payment obligations. During market downturns, if the fund does not have sufficient income and realized gains, it would need to pay these distributions from capital, reducing its asset base. Therefore, funds with managed distribution policies may tend to hold more cash and bonds than those without such a policy, all other things being equal.
How long has the taxable preferred securities market existed?
Regular preferred securities have been around for a long time. However, taxable preferred securities are relatively new, with the vast majority of new issues debuting after 1995. As of the first quarter of 2002, there have been $180 billion of taxable preferred securities issued. Approximately two-thirds of these taxable preferred securities are exchange listed, with the remainder trading in the over-the-counter market.
What makes taxable preferred securities different from regular preferred securities?
Unlike the tax treatment of typical preferred securities, taxable preferred securities do not qualify for the dividends-received deduction for corporations. They are often issued by trusts established by operating companies, and are not a direct obligation of the operating company. The trust is generally treated as transparent for federal income tax purposes such that the holders of the taxable preferred securities are treated as owning beneficial interests in the underlying debt of the operating company. Accordingly, payments of these securities are treated as interest rather than dividends for federal income tax purposes, and are not eligible for the dividends received deduction. Because taxable preferred securities do not quality for the tax-favorable dividends-received reduction, they generally offer higher yields than regular preferred securities.
Who are the buyers for $25 par taxable preferred securities?
Retail investors are the dominant segment investing in $25 par securities, perhaps due to the generally higher yield opportunities and perceived quality of the asset class.
Who are the buyers for $1000 par value taxable preferred securities?
These securities are almost exclusively owned by the institutional market, which includes insurance companies, pension funds, corporations and some mutual funds. A portion of these securities have actually been securitized in $25 units and offered to the retail market.
Why Were REITs Created?
Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to smaller investors. In the same way as shareholders benefit by owning stocks of other corporations, the stockholders of a REIT earn a pro rata share of the economic benefits that are derived from the production of income through commercial real estate ownership. REITs offer distinct advantages for investors; greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.
How Does a Company Qualify as a REIT?
In order for a company to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:
- be an entity that is taxable as a corporation;
- be managed by a board of directors or trustees;
- have shares that are fully transferable;
- have a minimum of 100 shareholders;
- have no more than 50 percent of the shares held by five or fewer individuals during the last half of each taxable year;
- invest at least 75 percent of the total assets in real estate assets;
- derive at least 75 percent of gross income from rents from real property, or interest on mortgages on real property;
- have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries;
- pay dividends of at least 90 percent of its taxable income in the form of shareholder dividends.
Who Invests in REITs?
Individual investors directly own REIT shares purchased on the open market. Other typical buyers of REITs are pension funds, endowment funds and foundations, insurance companies, bank trust departments and mutual funds. REIT shares typically may be purchased on the open market, with no minimum purchase required. Many investors may also own REITs through mutual funds that specialize in public real estate companies.
Investors may prefer to invest in REITs for their high levels of current income. In addition, investors looking for ways to diversify their investment portfolios beyond other common stocks as well as bonds are attracted to the unique characteristics of REITs.
How are REITs Different from Limited Partnerships?
REITs are not partnerships, although REITs use partnerships to engage in joint ventures. There are important organizational and operational differences between REITs and limited partnerships, especially in tax reporting.
An investor in a REIT receives a traditional IRS Form 1099 from the REIT, indicating the amount and type of income received during the year. An investor in a partnership receives a more complicated IRS Schedule K-1.
How do Shareholders Treat REIT Distributions for Tax Purposes?
REITs are required by law to distribute each year to their shareholders at least 90 percent of their taxable income. Thus, as investments, REITs tend to be among those companies paying the highest dividends.
For REITs, dividend distributions for tax purposes are allocated as ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. All public companies, including REITs, are required to provide their shareholders early in the year with information clarifying how the prior year's dividends should be allocated for tax purposes.
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What is an index ETF?
Like a traditional mutual fund, an index ETF is a investment structure that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. Unlike a mutual fund, an index ETF is created when an institutional investor deposits securities into the fund in return for creation units. In return for the deposit, the institutional investor receives a fixed amount of shares, some or all of which may be traded and priced throughout the day on a stock exchange such as the American Stock Exchange (AMEX). Retail investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund - rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of index ETFs.
Are basket-based products such as HOLDRs also index ETFs?
Actually, HOLDRs and other basket-based products are not truly index ETFs. This is a term that has evolved over the years and has been adopted by investors, but is not wholly accurate. A unit investment trust is not a fund. HOLDRs are grantor trusts, which are non-registered securities, not funds.
What is the difference between a unit investment trust and a managed investment company?
Unit investment trusts are created for a specific, limited purpose, and do not have a board of directors or an investment advisor. Therefore, these trusts do not make discretionary investment decisions. Funds operated by managed investment companies, however, do make discretionary investment decisions, at least within the confines of the fund investment guidelines.
Will index ETFs replace index mutual funds?
There is no consensus on this point of view, although the odds are against index ETFs replacing traditional index mutual funds. Due to the expense of dollar-cost averaging index ETFs for an active investment strategy (brokerage commissions must still be paid for each purchase or sale), traditional index mutual funds still hold a cost advantage.
Do investors receive the voting rights associated with the underlying stocks?
Provided that the index ETF is a registered investment company, the voting rights are held by the fund managers, not the fund shareholders. For those funds that are not registered investment companies, such as HOLDRs, the fund arranges for the delivery of proxy material to the investors, who do have voting rights associated with the underlying securities in the HOLDR trusts.
How do I buy and sell index ETFs?
Investors buy and sell index ETFs like stocks, typically through a brokerage account. Investors can also employ traditional stock trading techniques, including stop orders, limit orders, margin purchases, and short sales. As with all stocks, you may be required to deposit more money or securities into your margin account if the equity including the amount attributable to your index ETFs shares, in your account declines.
What are the tax implications of trading index ETFs?
Taxes must be paid on all dividend distributions made by the underlying securities and any capital gains associated with transactions made by the fund. However, since index ETFs offer in-kind redemptions, they can avoid realizing capital gains for the fund (although shareholders must still pay any taxes due upon most sales of the underlying securities).
How can I hold my index ETF?
Unlike other stocks, which can be held in book entry or certificate form, certificates are not available for most index ETFs. The only certificate is held by the Depository Trust Company, and the number of shares represented by that certificate is "marked to market" for increases and decreases in shares as creations and redemptions occur.
Are index ETF expenses low?
Due to reduced marketing and distribution expenses and the passive nature of index investing, the expense ratios are typically lower than those of many traditional mutual funds. For index ETFs that are not registered investment companies (i.e. HOLDRs), an annual custody fee of 0.08% is charged if any of the underlying stocks pay dividends. However, investors must still pay a brokerage commission to purchase and sell shares for all index ETFs. For those investors who trade frequently, this can significantly increase the cost of investing in index ETFs. So while index ETFs may have lower expense ratios, the total costs to the investor may not be lower.
In addition, shareholder accounting for index ETFs is maintained at the investor's brokerage firm, rather than at the fund. This creates no problems for the shareholder, although it does have some significance for the distribution of index ETFs. One of the traditional functions of the mutual fund transfer agent is to keep track of the salesperson responsible for the placement of a particular fund position, so that any ongoing payments based on 12b-1 fees or other marketing charges can be made to the credit of the appropriate salesperson. Index ETF expenses tend to reflect the cost savings of this function.
How is the net asset value and market price of an index ETF linked?
The price of an index ETF typically resembles, but is independent of, the underlying net-asset-value of the fund. Unlike closed-end ETFs, the shares for an index ETF can be created or deemed on a daily basis by market specialists. If the specialist is not maintaining an orderly market in a fund, and institution can exchange shares in-kind (in 50,000 share lots) to minimize any price to net asset value gap.
What is tracking error?
Tracking error is the difference between the returns of a fund and the returns of the index that it attempts to duplicate. This tracking error arises primarily because of the forces of supply and demand that determine market prices for these funds. The other type of tracking error, although less relevant to the investors as it does not influence fund performance, is the difference between the net asset value of the index ETF and the underlying index. This difference may arise due to product fees, difference in dividend handling and differences in index composition.
How do index ETFs handle dividends?
Index ETFs handle dividends in different ways. iShares reinvest dividends in the fund when they are paid. Most funds, such as SPY and QQQ, hold dividends in cash-equivalent instruments until a pre-determined distribution, typically at the end of each month or quarter. HOLDRs distribute cash dividends immediately. In any case, whether the fund distributes or reinvests the dividends, this is still a taxable event for the shareholder.
Why is the gap between the price and net asset value greater on some index ETFs than on others?
Fundamentally, the perceived value of a fund's shares may be less than the reported value of the fund's underlying assets. In addition, poor performance, illiquid securities, poor name recognition, and large unrealized gains may prompt a fund to trade at a discount. Tracking error is also introduced through fees and expenses (which are not incorporated in the underlying indexes) and optimization rather than replication (due to compliance with the 40 Act).
Do index ETFs use leverage?
Index ETFs do not currently use leverage. However, the SEC has approved the use of leverage for conventional index funds, so the use of leverage by index ETFs may not be far away.
Why do some investors purchase a basket of sector funds (that replicate a broad market index) instead of a broad market index fund?
For example, instead of purchasing the S&P Depository Receipts (SPY), an investor may purchase the nine Select Sector SPDRs. Although this may seem imprudent at first, the investor now has the ability to realize losses in specific sectors, whereas a broad market index does not have this ability. For example, in 1999, while the S&P 500 was up 19.1%, several constituent sectors were down. An investor that holds the underlying sector funds individually would be able to sell the poorly performing sectors to offset gains in the remainder of his portfolio. Please note that the sector used for the nine Select Sector SPDRs are determined by the Merrill Lynch Research Department, not Standard & Poor's.
Are there actively managed index ETFs?
Although there are currently no actively managed index ETFs in the United States, several such funds have been launched in Europe. These funds announce their holdings to market makers on a two-day lag and to the general public on a two-month lag. This information distribution process may be problematic for the SEC and the market makers in the United States, although there are ideas for appeasing these concerns.
What is the difference between an index ETF and a futures contract on an index?
Although an index ETF and a futures contract may represent ownership of the same underlying index, there are more index ETFs available for indexes than futures contracts, especially for style, sector and industry categories. Futures contracts depend on continuous customer order flow, while few of the style, sector and industry indexes are characterized by continuous order flow. In addition, index ETFs trade in much smaller investment sizes than futures contracts. For instance, the S&P 500 SPDR trades at five times less than the corresponding futures contract. Of course, investors may also prefer the ease of trading a stock rather than a futures contract, which requires separate accounts and daily mark-to-market of gains and losses.
How can I use index ETFs to manage my portfolio?
Index ETFs provide investors with exposure to broad segments markets. They cover a range of style and size spectrums, together with sector-specific funds, enabling investors to build customized investment portfolios consistent with their financial needs, risk tolerance, and investment horizon. Both institutional and retail investors use index ETFs to gain exposure that would otherwise be cost-prohibitive and extremely complex to build from scratch.
Can index ETFs be used to hedge portfolios?
Index ETFs can be an excellent hedging vehicle because they can be borrowed and sold short. The increasingly broad array of index ETFs is creating new risk management approaches that, until now, were available to large institutional investors only. The smaller denominations in which index ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.
What is the turnover difference between passively managed index-based ETFs and actively managed funds?
Indexes are rebalanced on a regular basis (ad hoc, monthly, quarterly, etc), which allows the indexes to maintain their desired characteristics. Index-based ETFs often rebalance concurrently with their underlying indexes. An index-based fund tracks a particular index, so there tends to be less portfolio turnover than with actively managed funds.
What is the difference between various fixed income indexes?
Just as equity indexes are based on different combinations of stocks (for example, the Standard & Poors 500 versus the Russell 2000), fixed income indexes are based on different combinations of fixed income securities. Generally, these fixed income indexes can represent various maturity ranges, bond ratings, or liquidity characteristics. For example, the Lehman Brothers 1-3 Year Treasury Index is a capitalization-weighted combination of publicly-issued, fixed-rate US Treasury securities (non-convertible) that have more than $150 million par value outstanding and maturities from one to three years. Since the underlying indexes represent various characteristics, investors with a view on the yield curve can make applicable investments.
Why do index-based fixed-income ETFs sometimes trade at a premium to NAV during days when the fixed income markets are closed?
The equity and fixed income markets do not always close on the same days. Several times during the year, index-based fixed-income ETFs will trade on US equity exchanges while the fixed-income markets are closed. In addition, US bond markets may only be open for a portion of the US equity trading day. For example, during Columbus Day, although index-based fixed-income ETFs can trade on the AMEX, the US bond markets are closed. These ETFs may trade at a discount or premium based on investor anticipation of bond appreciation the next trading day.
This phenomenon is similar to observed discounts/premiums in equity index futures before trading in the US equity markets begins. The futures may trade at a discount or premium based on investor anticipation of index appreciation when the equity markets open for trading.
Do index-based ETFs hold every security in the underlying index?
ETFs based on specific indexes may not hold every security in the underlying index. Many indexes contain illiquid or small capitalization securities that are costly to purchase and sell. In order to minimize transaction costs, these ETFs often use optimization techniques to design portfolios that will closely track the underlying index, but not necessarily hold all the securities in the underlying index. However, this strategy may also lead to tracking error.
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What are Auction-Rate Preferred Shares of Closed-End ETFs?
Auction-Rate Preferred Shares are a share class of the underlying Closed-End ETFs that seek to provide yields that compare favorably with short-term instruments, such as the 30-day yield for money market funds. Many municipal bond funds leverage their assets, in an attempt to increase common share yields when the yield curve is relatively flat and greater yields cannot be earned by lengthening investment maturities.
In order to leverage their assets, funds issue shares of preferred stock to investors. The proceeds received from these shares are then invested in the fund portfolio. Preferred shareholders receive a regular dividend based on short-term interest rates, ahead of any payments made to common shareholders.
How liquid are Auction-Rate Preferred Shares?
Auction-Rate Preferred Shares do not necessarily provide daily liquidity, but rather provide liquidity through a regularly scheduled auction process. These shares are purchased and sold at regular auctions conducted by fund sponsors. Investors submit bids through their broker's preferred stock desk, indicating the number of shares desired and the desired dividend rate.
Shareholders may also offer their shares for sale in the secondary market, although the amount received in the secondary market is subject to forces of supply and demand, and may be different than the original amount invested (and may involve a brokerage commission).
How often are dividends paid?
The distributions to preferred shareholders may be paid weekly, monthly or quarterly, according to the schedule set by the fund.
When do the rates paid to preferred shareholders reset?
Although this can vary from fund to fund, rates are typically reset weekly, monthly or quarterly.
How much can funds leverage their common shares?
Closed-End ETFs typically have a leverage ratio between 33% to 50% of assets. For example, a Closed-End ETF with $100 million in assets may borrow $50 million, for a ratio of $50/($100+$50) or 33%. Typically, only Closed-End ETFs that leverage through the issuance of preferred stock have leverage ratios approaching 50%.
What is the minimum asset coverage ratio for leveraged Closed-End ETFs?
The Investment Company Act of 1940 requires that a fund asset's coverage be at least 200% of assets to provide adequate protection for senior securities. Higher coverage provides for a greater margin of safety. For example, suppose a Closed-End ETF has $500 million in assets and wants to add $100 million of leverage (with a 7.5% cumulative preferred share issue). After issuing the preferred shares, the fund's capital structure would consist of $600 million in total assets, $100 for preferred shares and $500 for common shares. This results in a $600 million total shares / $100 million preferred shares, or a 600% asset coverage ratio.
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