ETFs mass appeal in Europe is still doubted

In spite of the many common features of European offered ETFs and US ETFs, doubts remain as to the ability of the former to mirror the latter's 1 Morgan Stanley, Exchange-Traded Funds Strategies, August 19, 2004. Table 9.1 Europe's iShares MSCI ETFs change in TER (bps) Table 9.1 Europe's iShares MSCI ETFs change in TER (bps) Source Morgan Stanley, February 1, 2005. success. Critics believe that it is one thing to rival the United States in terms of the number of traded ETFs, but quite another...

The Rebalancing Process

Both ETFs and index-based mutual funds share inherent tax efficiencies. As index funds, they have a relatively low turnover since they only buy and sell stocks to adjust for changes to their underlying benchmark. As such, both investment vehicles experience lower capital gains distributions and tax liability than their actively-managed funds counterparts. Actively managed This chapter draws from the author's previous work on the subject. See, A. Seddik Meziani, Along Came a SPDR How...

Harvesting tax losses

Several strategies are being proposed to improve tax returns, including one reflecting the findings in a seminal article by Constandinides (1983), showing that it is optimal for investors to realize losses and defer gains through a procedure known as tax-loss harvesting.2 This strategy can be illustrated through a simple example. Suppose an investor has a total of 100,000 to invest in the beginning of 2003. The first investment, in the amount of 30,000, represents a sector play, as described in...

Main Differentiating Characteristics Of Market Indexes

Once an asset manager has decided to pursue an index strategy, the next step is to select an appropriate benchmark. Although market indexes tend to move in unison, there are important differences in the magnitude of these moves. Whether passive investors prefer indexed mutual funds, favor ETFs, or an asset allocation strategy that uses both, they need to understand how these indexes are compiled as the differences in construction can lead to significant differences in returns. Indeed, we cannot...

Strategy 4 Many ETFs are considered similar yet are certainly not identical

To illustrate, assume that the hypothetical investor sells 200 shares of the iShares Dow Jones Technology-Index (IYW) at a loss. Repurchasing within the disallowed period the same number of shares of the IYW for tax purposes will be disallowed by the IRS. Realized losses cannot be applied against the capital gains distributions our investor could receive, without triggering the wash-sale rule. However, the loss on the sale of the IYW could be claimed without violating the wash-sale rule if...

Actual Tax Savings Methodology

In order to assess the potential tax savings of ETFs over competing indexed mutual funds, we will compare the SPDR 500 (SPY) and the Vanguard 500 (VFINX). The former accounts for over 26 of the ETF market 1 This chapter draws from the author's previous work on the subject. See, A. Seddik Meziani, Along Came a SPDR How Tax-Efficient are S& P Depositary Receipts in A Guide to Exchange-Traded Funds, Institutional Investor, Fall 2001, pp. 144-154. Source American Stock Exchange (October 1,...

Taxfree inkind redemption

When a unit holder of the ETF Trust requests redemption, the Trust may distribute securities and or cash. In the case of cash, no capital gain is involved on the part of the Trust. However, in the case of securities, the current market value of the securities may have gone up should the Trust recognize the capital gain or loss Internal Revenue Code Section 311(b) provides that if a corporation distributes property to a shareholder and the fair market value of such property exceeds its adjusted...

The 12b1 fee

The cost differential shown in Table 3.2 is also due to a charge called the 12(b)-1 fee.9 This charge is levied to cover the cost of marketing and distributing the fund. Assessed annually for as long as the fund is owned, it can amount to as much as 1 . Box 3.2 describes how mutual funds use 12(b)-1 fees. Unlike mutual funds, ETFs can only be purchased through brokers rather than directly from the fund sponsors. Sponsors do not sell shares directly to the public. Therefore, they save the cost...

Tax Efficiency Of Redemption

As noted, the distribution of stock by the trust to ETF shareholders for redemption does not realize any capital gains. Moreover, ETF managers can also chose to distribute low-cost stocks to the redeeming shareholders, leaving high-cost stocks in the portfolio's holdings. Later, when these high-cost stocks are sold, lower capital gains will be realized. Hence, ETF redemptions provide an opportunity for their managers to avoid capital gains. If these acts are well - coordinated, the ETF Trust...

The premium and discount issue of international ETFs

Due to their hybrid nature, ETFs present portfolio managers with additional risks. Generally speaking, as discussed in chapter 3, the market price is determined by supply and demand for these funds because they trade like securities. As such, a specialist can create or redeem ETFs through creation units new shares are created to meet demand or terminated to control supply. Yet, although it is true that the market price of any ETF is largely driven by the underlying value of the portfolio, they...

Market indexes as proxy for systematic risk

Last but not the least, the concept of systematic risk has also contributed to the use of market indicator series. Also known as market risk, it stems from factors that systematically affect most firms, such as high interest rates, inflation, recessions, and war. Since most stocks are negatively affected by these factors, market risk cannot be eliminated by diversification. Hence, it is also known as undiversifiable risk. Since this risk is inherent in the market, it can be measured by the...

Fair pricing and liquidity

ETF pricing and liquidity stem from three main sources the creation and redemption process the trading of shares on the secondary market and transparency. ETFs do not have a fixed number of shares.2 Authorized participants or market makers can issue and redeem shares of the ETF fund at any time, in large blocks of the fund's shares, called creation units or a standard basket, these replicate the underlying index. Authorized participants are those broker dealers, institutional investors, or...

The case for bond indexing

A strong case can be made for indexed bond investments. Several of the factors that explain the phenomenal growth of equity indexing equally justify the popularity of bond indexing. First and foremost, bonds are also an integral part of modern portfolio theory. As a widely recognized asset class, they occupy an important position in any portfolio that claims to be strategically balanced regardless of whether this portfolio is actively or passively managed. As with equity portfolios, the issue...

Indexing and ETFs

ETFs are an outgrowth of index funds. Like with index funds, investors can take a position in the market without selecting individual securities. ETFs represent a basket of securities based on a particular index. Purchases or redemptions of an index fund, however, only occur at the end of the day when the fund's net asset value is calculated. ETFs overcome this limitation since they trade continuously on the major stock exchanges like ordinary stocks. Hence ETFs offer investors the benefits of...