Correcting three misconceptions about ETFs

Jul 8, 2019 @ 12:01 am

By Evan Cooper

There are probably no hard numbers to prove it but I'm guessing the odds are good that, despite the increasing popularity of exchange traded funds, most investors don't really understand the mechanics of them.

It's not that being an expert in the plumbing of the securities industry is needed to invest knowledgeably and prudently. Most successful equity investors, for example, have no clue as to how trades are cleared and settled, which has impeded them not one whit. It's sort of analogous to driving a car: We need not understand the complexity of automatic transmission in order to shift the gear lever from R to D and successfully go about driving.

But because the under-the-hood aspects of ETFs are at best hazily understood, and because exchange traded funds are similar to, yet different from, conventional mutual funds, many investors hold notions about them that are based on fact, fiction and often a mix of both.

Here are three common misconceptions of ETFs — along with a thumbnail explanation of the reality — that can help advisors explain exchange traded funds to investors so they can better understand how these vehicles can be a useful component of investment portfolios.

Misconception #1: ETFs are liquid.

This misconception arises from the way ETFs are constructed, leading to two different types of ETF liquidity, as well as misconceptions about the “cost” of liquidity.

For clients of financial advisers, the main concern is secondary market liquidity. This is the measure of the ease with which an investor can buy or sell an ETF during the trading day as they would a conventional share of stock. As with all stocks, secondary market liquidity is determined by the demand and supply of shares at a particular moment. In other words, the more people there are buying and selling shares in a particular ETF at a particular time, the more liquid that ETF is.

Questions about secondary market liquidity often arise from misunderstandings about liquidity in the primary market for ETFs. Liquidity in the primary market is driven by the profit motive of each participant in the process. By swapping underlying shares for ETFs and vice versa, large investors are arbitraging both markets, or trying to capture the profit potential from minute price differences between the price of the underlying shares and the price of ETF shares. That process of buying and selling among market professionals closes the gap between the value of the underlying shares and the ETF and makes ETF pricing fair and efficient.

As in every market, the relative level of liquidity is expressed in the bid-ask spread, or the gap between what sellers want to receive and what buyers are willing to pay.

Trading in the secondary market and incentives for market professionals in the primary market, therefore, potentially making ETFs liquid investment vehicles.

Misconception #2: All ETFs are passive.

The first ETF, and now one of the most-traded securities in the world, is the passively managed SPDR® S&P 500® ETF Trust. The ETF tracks the Standard & Poor's 500 Stock Index. Its success, as well as the widening popularity of ETFs and innovations by financial firms, spawned new types of exchange traded funds. Actively managed ETFs constitute one such type, in which the securities that constitute the fund are selected by a manager rather than by passively following an established index. The goal of actively managed ETFs is to outperform a benchmark index. Another type of ETF is a mix of active and passive strategies. These socalled “smart beta” ETFs are intended to outperform index-based ETFs by using a different weighting standard than traditional market-capitalization weighting. By using alternative weighting measures based on volatility, liquidity, size and other factors including fundamentals, smart- beta ETFs try to take advantage of market inefficiencies. Because they passively follow a blueprint created by active managers, smart-beta ETFs are a hybrid of passive and active management.

Misconception #3: ETFs don't pay dividends.

If the stocks that comprise an exchange traded fund pay dividends, then owners of that ETF receive their pro rata share of those dividends based on the number of ETF shares they own. While some ETFs pay out dividends as soon as they receive them from the companies whose underlying shares they own, most ETFs hold all of the dividends paid by those underlying stocks during the quarter and then make a quarterly payment. Often, ETF shareholders can choose to receive the dividend in the form of cash or as a reinvestment in additional ETF shares. The ETF prospectus states if and how an ETF pays a dividend.

Important Risk Discussion This material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. A smart beta ETF is a type of exchange traded fund that uses a rules-based system for selecting investments to be included in the fund. Investing involves risk including loss of principal. Dividends are not guaranteed and a company's future abilities to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time. State Street Global Advisors and InvestmentNews are not affiliated. SPDR®, S&P and S&P 500 are registered trademarks of Standard & Poor's Financial Services LLC (S&P), a division of S&P Global, and have been licensed for use by State Street Corporation. No financial product offered by State Street or its affiliates if sponsored, endorsed, sold or promoted by S&P. State Street Global Advisors Funds Distributors LLC, member FINRA SIPC. ALPS Distributors, Inc., member FINRA, is the distributor for SPDR S&P 500 ETF Trust, a unit investment trust. ALPS Distributors, Inc. is not affiliated with State Street Global Advisors Funds Distributors, LLC. Before investing, consider the funds' investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call 1-866-787-2257 or visit www.spdrs.com. Read it carefully. Not FDIC Insured — No Bank Guarantee — May Lose Value Exp date 7/31/2020 2535597.1.1.AM.RTL

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