Exchange-Traded Funds (ETFs)

Now that you understand how ETPs trade, let's look at the most common type: the exchange-traded fund.

What Is an ETF?

• Most are registered investment companies (open-end funds or UITs) under the Investment Company Act of 1940; commodity- and currency-based ETFs (for example gold or oil ETFs) are grantor trusts or commodity pools and are not registered investment companies
• Hold a portfolio of securities (stocks, bonds, commodities, etc.)
• Shares represent ownership in the underlying portfolio of securities
• Most ETFs track an index (passive management)
• Some ETFs are actively managed (a fund manager selects securities)

Well-known index ETFs you should recognize:

Exam Tip: Gotchas

• Most ETFs are registered investment companies under the 1940 Act. ETNs (exchange-traded notes) are NOT. ETNs are unsecured debt obligations. If the exam asks about 1940 Act registration, the answer is ETFs, not ETNs.

The Creation/Redemption Mechanism

This is the feature that makes ETFs unique. It's also what keeps ETF market prices close to NAV.

How it works:

• Authorized participants (APs) are large institutional investors or broker-dealers that work directly with the ETF issuer
• APs create and redeem large blocks of ETF shares called creation units (typically 10,000-100,000 shares)
• Creation: The AP delivers a basket of the underlying securities to the ETF issuer and receives ETF shares in return
• Redemption: The AP delivers ETF shares back to the issuer and receives the underlying basket of securities

Why this matters:

• If the ETF trades at a premium to NAV (market price > NAV), APs buy the cheaper underlying securities and create new ETF shares to sell at the higher price
• If the ETF trades at a discount to NAV (market price < NAV), APs buy the cheaper ETF shares and redeem them for the more valuable underlying securities
• This arbitrage process keeps the ETF market price closely aligned with NAV

Exam Tip: Gotchas

• Individual investors do NOT participate in the creation/redemption process. They buy and sell ETF shares on the exchange (secondary market) like any other stock. Only authorized participants (APs) interact directly with the ETF issuer.

In-Kind Transactions and Tax Efficiency

• Creation and redemption transactions are typically done in-kind (securities exchanged for ETF shares, not cash)
• In-kind transfers are not taxable events, giving ETFs a major structural advantage
• Result: ETFs distribute far fewer capital gains to shareholders than mutual funds
• Most mutual funds pay annual capital-gains distributions; only a small share of ETFs do

Think of it this way: When a mutual fund sells a stock at a profit, it must distribute that gain to shareholders (who owe taxes on it). ETFs avoid this because the creation/redemption process swaps securities in-kind, so no sale occurs at the fund level. The tax bill gets deferred until the individual investor sells their own ETF shares.

Exam Tip: Gotchas

• ETF tax efficiency comes from the in-kind creation/redemption process, not from lower turnover alone. The structural mechanism (securities swapped, not sold) is what avoids triggering capital gains at the fund level.

ETF Advantages Over Mutual Funds

• Intraday trading - buy/sell at any time during market hours at market price
• Lower expense ratios - especially passive/index ETFs (often 0.03%-0.20%)
• Tax efficiency - creation/redemption process minimizes capital gains distributions
• Transparency - most ETFs disclose holdings daily
• No minimum investment - can buy as few as 1 share (or fractional shares)
• No sales loads - no front-end or back-end charges (though brokerage commissions may apply)

ETF Disadvantages

• Brokerage commissions on each trade (though many brokers now offer commission-free ETF trades)
• Bid-ask spread - the difference between buy and sell price is a cost of trading
• May trade at a slight premium or discount to NAV
• No breakpoints, letters of intent (LOI), or rights of accumulation (ROA) (unlike Class A mutual fund shares)

Exam Tip: Gotchas

• ETFs do NOT offer breakpoints, letters of intent (LOI), or rights of accumulation (ROA). These volume discount features are exclusive to mutual fund Class A shares. If a question mentions breakpoints, the answer is mutual funds, not ETFs.

What Should You Check on Exam Day?

• Can you explain how authorized participants use creation and redemption to keep ETF prices near NAV?
• Do you know why individual investors cannot take part in the creation and redemption process?
• Can you explain why in-kind transfers make ETFs more tax-efficient than mutual funds?
• Do you know which volume discount features ETFs do not offer, unlike Class A mutual fund shares?
• Can you explain why commodity- and currency-based ETFs are not registered investment companies?