How ETFs Work – And Why All Investors are the Beneficiaries

By Jack Forehand (@practicalquant) —

Wall Street has a reputation for enhancing itself at the expense of the individual investor. And that reputation is well deserved. It has been very common throughout history for firms on Wall Street to develop products whose primary goal is to make money rather than adding value for the investors who purchase them. So if you are looking for someone to defend the practices of Wall Street, I am not that guy. But that reputation sometimes leads people to always assume the worst and always think that individual investors are always getting the short end of the stick.

A recent article in Bloomberg called into question whether ETFs are being used as a tax dodge by large institutions via what the authors call “heartbeat” transactions that are used as a method to avoid taxes. I think this suggestion is a misrepresentation of what is going on and doesn’t properly reflect the many benefits individual investors get from the process they are referring to. In order to understand why that is, it is important to first take a step back and look at how ETFs work.

But before I go further, I think it is important that I disclose my own bias. Our separate investment management firm, Validea Capital Management, is an issuer of an ETF and I am a portfolio manager of that ETF. I don’t discuss that ETF on this blog or on social media so I won’t name it here, but I think it is important that I disclose any personal interest I have in any topics I write about so I wanted to make that clear.

Both mutual funds and ETFs operate using an open-ended structure.  They pool together the capital of their investors and as more investors invest in them they issue new shares and their assets rise. Investors can purchase shares of a mutual fund once per day at the closing net asset value. When new money flows into a mutual fund, the manager will typically deploy it into their holdings. When money flows out, the manager will sell holdings to free up the cash to meet those redemptions.

Mutual Funds vs. ETFs

When mutual funds sell holdings that have appreciated, whether it be because they have to due to investor redemptions or because they want to as part of a portfolio rebalancing, they can generate taxable gains. If the net gains of a fund are positive at the end of the year, those gains are passed on to shareholders via a capital gains distribution. These distributions are not optimal for long-term investors because they generate a tax liability regardless of whether an investor actually sells their shares. So an investor in a mutual fund is in many ways subject to the decisions of others with respect to their tax liability. If other investors decide to sell their shares, it can create a tax liability for those who continue to hold. If an investor invests in a fund with significant gains prior to their investment and then the manager realizes those gains, that investor can incur a tax liability as well, even though they did not participate in those gains.

ETFs are different than mutual funds in several major ways. The first is that they trade throughout the day. The second is that they disclose their holdings each day via their website (mutual funds report holdings quarterly on a delayed basis). But the most important difference for the purpose of this discussion is that ETFs are more tax efficient and feature mechanisms to address the tax issues I outlined above with mutual funds. All of these differences are interrelated in a way that will become clear as I explain it further.

While mutual funds create or redeem shares each night at their net asset value, ETFs need a way to do it during the trading day. This is where creation and redemption transactions come into play and it is also where all the differences with mutual funds I outlined above come together. For ETFs to trade throughout the trading day, the first thing that is required is for the market to know the value of their shares. This is where the fact that ETFs disclose their holdings daily is important. Daily disclosure allows market participants to see exactly what ETFs hold and therefore determine their NAV throughout the day. Authorized participants can create or redeem ETF shares at any time, which both keeps the price of an ETF close to its NAV and significantly improves tax efficiency.

The easiest way to understand how the ETF creation and redemption process works is to look at a simple example.

A Simple Example

Let’s assume that I launch an ETF today and my initial portfolio will contain two stocks, Apple and Amazon. ETF shares are issued in fixed amounts which are called creation units. Each unit typically represents 50,000 shares of the ETF.  To bring my ETF to market, the first thing I will need is someone to facilitate the trading of it and to issue the initial batch of these creation units. This will require a lead market maker and seed capital. Most ETFs come to market with 100,000 shares trading at $25 (two 50,000 share creation units). That means I need $2.5 million to get things started. For the purposes of this simple example, we will assume that my lead market maker is providing that capital.

On my first trading day, the market maker would execute a creation transaction. The creation is a tax-free transaction where the market maker receives the ETF shares that are needed to get the ETF trading, and in exchange they provide the fund with an equal dollar value of the stocks in its portfolio. So in this case the market maker gets $2.5 million in ETF shares and the fund gets $1.25 million each of Apple and Amazon. The transaction balances out and is tax free for both sides. The market maker will now use those 100,000 shares it has to make the initial market in the ETF.

Now let’s assume that my ETF performs really well and investors start to accumulate shares of the fund.At some point, the market maker will run out of the 100,000 shares and won’t have shares to sell to new investors. They can easily resolve that problem by issuing new shares in those same 50,000 share increments. Every time they do it, they get 50,000 shares and the fund gets an equal amount of its holdings.

So far the process has been fairly straight forward. My new ETF was launched and new shares were issued on an ongoing basis in response to demand.

Now let’s look at the two situations that generated capital gains distributions for mutual fund holders in the previous example.

First, let’s assume that my two-stock portfolio starts to perform poorly and investors withdraw money from the fund and sell their shares. Now my market maker will begin to build up an inventory of shares they are buying from all the sellers. At some point, their inventory will become more than they want to hold. This might seem like a significant problem for them, but in reality, it is quite easy to resolve. Just like they could create shares of my ETF on demand, they can also redeem them. The redeem transaction is just the opposite of the create. The market maker gives 50,000 ETF shares back to the fund (effectively destroying them), and in exchange the fund gives them an equal value of the two stocks it holds and fund assets fall. This is a tax-free transaction so even if the fund has a gain on those shares, the gain is not passed on to shareholders. This is the first major difference between ETFs and mutual funds when it comes to taxes. If a mutual fund has to sell appreciated stock to meet redemptions, those gains will be passed on to shareholders in the form of capital gains distribution (assuming the fund has net gains at the end of its fiscal year).  But with an ETF, the shareholders that remain in the fund are not punished for the decisions of other shareholders to sell.

What Those “Heartbeats” Really Are

There is also one other time when the ETF structure helps prevent capital gains distributions from being passed on to shareholders. This is the situation the Bloomberg article referred to as “Heartbeats”. The name people in the ETF industry use for these transactions is custom creates and redeems. Custom create and redeem transactions follow the same principle as the standard creates and redeems I discussed above, but with one major difference. Custom creates and redeems allow the fund to specify which securities from their portfolio are included in the transaction. The best way to illustrate this is to return to our example. Let’s say I am a great stock picker and my position in Amazon doubles. Now I decide that I want to take my gains and buy Microsoft instead. I can work with an authorized participant (someone who is allowed to perform create and redeem transactions) to execute a custom redeem transaction where I can give them just my Amazon position in exchange for the shares of my ETF they redeem instead of giving them my whole portfolio. The net result is that I am able to remove Amazon via a tax-free exchange and the fund does not realize any gains. If I continue to use that method throughout the year to remove my gaining positions, then my fund will not have gains that need to be passed on to shareholders at year end and there will be no capital gains distribution.

ETFs Benefit the Long-Term Investor

The net result of all of this is that ETFs are able to both meet redemptions and sell their gaining positions without causing tax implications for shareholders. It doesn’t make the tax go away. It just means that shareholders get to decide when their gains are realized based on when they decide to sell their shares. This is a significant benefit for shareholders of ETFs relative to shareholders of mutual funds. It also rewards good investing behavior by offering benefits to those who hold ETFs for the long-run by allowing them to only pay taxes on their gains when they sell.

In the end, ETFs offer a fund structure that is very friendly for long-term investors. In my opinion, the way the Bloomberg article represented the creation and redemption process as one that benefits large Wall Street insiders was misleading . When you look under the hood at how ETFs work, it is clear they are not setup for the benefit of large institutions at the expense of everyday investors.  The biggest beneficiaries are all of us who use ETFs as long-term investments.

Photo: / Copyright : Jrg Stber

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.