Since 1996, Bloomberg Press has published books for finance professionals on investing, economics, and policy affecting investors. Titles are written by leading practitioners and authorities, and have been translated into more than 20 languages.

The Bloomberg Financial Series provides both core reference knowledge and actionable information for finance professionals. The books are written by experts familiar with the work flows, challenges, and demands of investment professionals who trade the markets, manage money, and analyze investments in their capacity of growing and protecting wealth, hedging risk, and generating revenue.

Books in the series include:

Visual Guide to Candlestick Charting by Michael Thomsett

Visual Guide to Municipal Bonds by Robert Doty

Visual Guide to Financial Markets by David Wilson

Visual Guide to Chart Patterns by Thomas N. Bulkowski

Visual Guide to ETFs by David J. Abner

Visual Guide to Options by Jared Levy

For more information, please visit our Web site at

Visual Guide to


David J. Abner


For Denise

Copyright ©2013 by David J. Abner. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with ­standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at For more information about Wiley products, visit

Library of Congress Cataloging-in-Publication Data:

Abner, David J., 1969

Visual guide to ETFs / David J. Abner.
    p. cm. — (Bloomberg press series)
Includes index.
ISBN 978-1-118-20465-8 (pbk.); ISBN 978-1-118-22838-8 (ebk); ISBN 978-1-118-23158-6 (ebk); ISBN 978-1-118-26561-1 (ebk); ISBN 978-1-118-52394-0 (ebk); ISBN 978-1-118-52387-2 (ebk); ISBN 978-1-118-52397-1 (ebk)
1. Exchange traded funds. I. Title.
HG6043.A263 2013




List of Exhibits

How to Use This Book



Chapter 1: Characteristics of Modern Investment Products

Chapter 2: Understanding How ETF Portfolios Work: The Primary Markets

Chapter 3: Understanding the Short Interest of ETFs

Chapter 4: Trading and Liquidity of the ETF Markets: The Secondary Markets

Chapter 5: ETFs and the Flash Crash

Chapter 6: How to Execute Orders in ETFs

Chapter 7: Examining ETF Trading Strategies

Chapter 8: Product Labeling and Structural Impact

Chapter 9: Where to Find ETF Information

Appendix: Bloomberg Functionality Cheat Sheet



List of Exhibits

Exhibit 1.1: Investment Company Total Net Assets (in $billions) by Type

Exhibit 1.2: SPY Price Spread Example

Exhibit 1.3: ETF Market Participants

Exhibit 1.4: ETF Description (DES), Holdings

Exhibit 1.5: Number of ETFs and Assets both in the United States and Globally

Exhibit 1.6: Fund Search Screen

Figure 1.7: Funds Launched and Closed per Year and Current AuM

Exhibit 1.8: Bloomberg Closed Funds Screen

Exhibit 1.9: ETF Breakdown by Volume Bucket and Age since Inception

Exhibit 1.10: Breakdown of U.S. Mutual Fund Assets; Percentage by Type of Fund, Year-End 2011

Exhibit 1.11: Number of Investment Companies by Type

Exhibit 1.12: CEF Discount Chart (ADX NAV)

Exhibit 1.13: Bloomberg Typing Code—ADX NAV

Exhibit 1.14: CEF Discount Chart (CLM)

Exhibit 1.15: CEF Discount Chart (NRO)

Exhibit 2.1: ETF Holdings (MHD)

Exhibit 2.2: ETF Creation Unit

Exhibit 2.3: Shares Outstanding and Volume

Exhibit 2.4: Shares Outstanding and Price

Exhibit 2.5: Shares Outstanding and Redemption

Exhibit 2.6: Looking at Historical Volume (HP)

Exhibit 2.7: Looking at Large Trade Blocks (AQR)

Exhibit 2.8: Looking at a Trade Summary (TSM)

Exhibit 2.9: ETF Creation Process

Exhibit 2.10: ETF Redemption Process

Exhibit 2.11: Looking at Historical NAV (NV HP)

Exhibit 2.12: Indicative Value DES Screenshot

Exhibit 2.13: Simplified eNAV Calculation

Exhibit 2.14: ETF Spread Components

Exhibit 3.1: Table of Short Interest in ETFs: Twenty ETPs with Highest Ratio of Short Interest to Shares Outstanding

Exhibit 3.2: ETF Short Interest (SI)

Exhibit 3.3: The Lending Tree: An Example of the ETF Shareholder Chain

Exhibit 3.4: Table Showing Percent of Stock Float Held by an ETF

Exhibit 3.5: Days to Cover Short Interest—All Shares

Exhibit 3.6: Days to Cover Short Interest—Excess Shares Only

Exhibit 3.7: Percent of Float

Exhibit 4.1: ETF Price Spreads (QRM)

Exhibit 4.2: Level II Quote Screen (MDM)

Exhibit 4.3: ETF Volume—Domestic (HP)

Exhibit 4.4: ETF Volume—International (HP)

Exhibit 4.5: Total ETF Liquidity

Exhibit 4.6: ETF Implied Liquidity (IDTS)

Exhibit 4.7: Table of Funds with High ETF Implied Liquidity

Exhibit 4.8: The Lowest IDTS Numbers for an ETF

Exhibit 4.9: The Implied Liquidity of the Largest ETF

Exhibit 4.10: The Implied Liquidity for Three Comparable ETFs

Exhibit 4.11: ETF Basket Implied Liquidity Scale—Dollars

Exhibit 4.12: ETF Basket Implied Liquidity Scale—Shares

Exhibit 4.13: EBILS Rating Grid

Exhibit 4.14: EBILS Rating Listing

Exhibit 5.1: SPY ETF Trade Price and Volume on May 6, 2010

Exibit 5.2 According to the SEC Findings, the Timetable of What Happened on May 6, 2010

Exhibit 6.1: The Long Tail of ETF Volumes

Exhibit 6.2: ETF Large Blocks

Exhibit 6.3: Trade Flow before Liquidity Aggregators

Exhibit 6.4: Trade Flow with Liquidity Aggregators

Exhibit 6.5: ETF Broker Rankings

Exhibit 6.6: Indications of Interest keystroke

Exhibit 7.1: Checking for High-Volume Days (HP)

Exhibit 7.2: Checking for Large Blocks (AQR)

Exhibit 7.3: Checking the Spread (QRM)

Exhibit 7.4: Looking for Shares Outstanding Changes (SO HP)

Exhibit 7.5: Transaction Cost Analysis

Exhibit 7.6: Isolating High-Volume Days (HP)

Exhibit 7.7: Checking for Large Blocks (AQR)

Exhibit 7.8: Checking Distance from the Market (QRM)

Exhibit 7.9: Checking for High-Volume Days (HP)

Exhibit 7.10: Checking for Large Blocks (AQR)

Exhibit 7.11: Checking Distance from the Market (QRM)

Exhibit 7.12: Checking Indicative Value (IV QR)

Exhibit 7.13: Checking for High-Volume Days

Exhibit 7.14: Checking for Large Blocks (AQR)

Exhibit 7.15: Checking Distance from the Market (QRM)

Exhibit 7.16: Checking Changes in the Market (QRM)

Exhibit 7.17: Checking Indicative Value (IV QR)

Exhibit 7.18: ETF Historical Price and Volume

Exhibit 7.19: ETF Quote Recap

Exhibit 7.20: ETF Quote Montage

Exhibit 7.21: ETF Large Block Recap

Exhibit 7.22: ETF Streaming Bid/Ask/Trades

Exhibit 7.23: ETF Intraday Price Graph with Extraordinary Trade

Exhibit 8.1: The ETP Umbrella

Exhibit 8.2: The DES Screen Shows the Type of Fund and a Group of Appropriations Regarding the Underlying Holdings

Exhibit 8.3: Comparing Index and ETF Returns

Exhibit 8.4: Premium Chart of a China ETF

Exhibit 8.5: ETF with Easy to Access Underlying Holdings

Exhibit 8.6: Indian Note Premium

Exhibit 8.7: Indian ETF Premium/Discount Oscillator

Exhibit 8.8: Halted Underlying Holdings Chart

Exhibit 8.9: Halted Creations Chart

Exhibit 8.10: Chart Showing Diverging Performance of a Futures-Based ETF

Exhibit 8.11: Performance between Two Similar ETFs

Exhibit 9.1: ETF Screener

Exhibit 9.2: ETF Screener

Exhibit 9.3: ETF Screens by Stock Holding

Exhibit 9.4: Index Universe Data Tool

Exhibit 9.5: Morningstar ETF Screener

Exhibit 9.6: ETF Screener by Issuer

Exhibit 9.7: Single ETF Information

Exhibit A.1: Bloomberg Typing Code = DTN DES

Exhibit A.2: ETF Description (DES)

Exhibit A.3: Bloomberg Typing Code = DTNIV DES

Exhibit A.4: Bloomberg Typing Code = DTNSO GPO

Exhibit A.5: Shares Outstanding Historical Chart

Exhibit A.6: Bloomberg Typing Code = DEMSO COMP

Exhibit A.7: Shares Outstanding Multi-ETF Chart

Exhibit A.8: ETF Ownership (DES, 4)

Exhibit A.9: Correlation Grid (CORR)

Exhibit A.10: Intraday Candle Chart (IGPC)

Exhibit A.11: ETF and IV Spread Charts—Domestic (SGIP)

Exhibit A.12: ETF and IV Spread Chart—International (SGIP)


How to Use This Book

The Bloomberg Visual Guide to … series is designed to be a comprehensive and easy-to-follow guide on today’s most relevant finance and investing topics. All charts are in full color and presented in a large format to make them easy to read and use. We’ve also included the following elements to reinforce key information and processes:

Go Beyond Print

Every Bloomberg Visual Guide is also available as an e-book, which includes the following features:



ETFs are the democratizing structure of investment management. They enable investors with portfolios of all sizes to play on the same ball field with the same information at the same low prices. Investors can now use the ETF market to build fully diversified portfolios to rival the returns of the best money managers. Investors can have access to short exposure without a stock loan account. They can have access to precious metals without the need to pay for a far-off storage bin. They can trade whole indexes with a single keystroke. And they can do it all at a fraction of what it once cost. These are indeed glory days of investment products providing real value and indisputable benefits to investors and their investment managers.

Two decisions lie at the basis of every investment: What is the desired exposure, and what is the correct product structure to efficiently achieve that exposure? The ETF market explosion of recent years has provided a resounding answer to the second question. This growth has created a tremendous need for education about utilizing this modern structure. That is the direct reason for the existence of the Visual Guide to ETFs.

The trusted financial advisors and portfolio managers that investors turn to for help in all matters financial have now become the navigators of the ETF marketplace. This is no easy task. The ETF market is a close cousin to the mutual fund market, but the products possess some unique intricacies that must be fully understood. This book presents the keys to a vast world of modern financial products. The material is presented in logical order and in small, easily digestible pieces. It can be used as a reference guide to the ETF universe and its tools for investment management. If you are managing any type of portfolio that includes ETFs, the information presented in this book can save you vast amounts of money.

The Visual Guide to ETFs begins with a clear and concise description of ETFs and their differences from mutual funds and closed-end funds. In Chapter 1, you will gain a deeper understanding of the basics of the structure: transparency, exchange listing, tax efficiency, and lower costs. You will also see some interesting statistics about the growth of the products and what the future may bring. Then in Chapter 2, you will find a detailed explanation of how the underlying portfolios of the funds work. The details of asset growth and the creation and redemption process ­enable readers to more fully understand what is happening as assets move in and out of the funds. This is followed by a deep analysis of the short interest of ETFs in Chapter 3.

In Chapter 4, we start to look at the trading of the products in the secondary markets. We examine trading strategies for positioning the funds in your portfolio and delineate the various market participants and their roles. The Visual Guide to ETFs provides the most in-depth available analysis of the liquidity of ETFs. There is a full explanation of ETF implied liquidity, the implied daily tradable shares, and the completely new and unique ETF basket implied liquidity scale (EBILS). In Chapter 5, there is a detailed accounting of what occurred within the ETF market during the flash crash of 2010. In Chapters 6 and 7, you’ll see detailed explanations for executing order flow in ETFs and strategies for trading the products. In Chapter 8, we look in depth at the various structures of exchange-traded products and how they can provide very different return results than those from seemingly similar investment exposures. And in Chapter 9, we look at some additional sources of information that are available. Finally, in the Appendix, there is a guide to the numerous Bloomberg functions for analyzing ETFs. The book is packed with more than 200 Bloomberg screens and callouts highlighting key points and important terminology for investors.

The thorough information in the Visual Guide to ETFs enables readers to deftly navigate the ETF marketplace. You will understand the product structures along with their benefits and pitfalls. You will understand different ways to determine the potential liquidity of ETFs. And you will learn strategies to trade ETFs like a professional trader. Readers are able to use this information to confidently and competently build ETF portfolios.



My goal with The Visual Guide to ETFs was to distill the necessary information for readers to use as a guide for their own investment situation, whether a small personal account or the largest institutional portfolio. In gathering my thoughts, organizing my data, stress-testing my conclusions, and formulating my words, I’ve had much assistance. Two people who have been involved in every step of both my books are Lynne Cohen and Anita Rausch. It’s incredible luck to have a mother-in-law who is a good sounding board and also a brilliant editor. Thanks, Lynne! Anita has read and rephrased many sentences in my books, applying her mastery of the product set to my thoughts or, sometimes, toning down my emotions. It’s incredible that she found the time while busy as a new mother, and for that I’m forever thankful.

The entire WisdomTree team has always been supportive of my work.1 I cannot thank them enough. It’s truly an honor to work with such driven and dedicated people. Zach Hascoe, my reality sounding board, is one of the most rational and clear-thinking people I’ve ever met. I also want to specifically thank Luciano Siracusano for helping me clarify my thinking on many points and Evelyn Hu for putting together a significant portion of the chapter on structure.

I am lucky to have great friends who are also incredibly knowledgeable industry participants: Robert Bastone, Eric Biegeleisen, Tim Coyne, Rob Dailey, Greg Gliner, Dana Martin, Andy McOrmond, David Morton, Adam Phillips, Damon Walvoord, and Robert Wedeking. Their different views of the industry enabled me to see from various angles and be certain that what I have presented passes all the tests. Sumit Periwal was a great help with some of the data found throughout the book. Gabe Pincus is a veritable wealth of information regarding underlying industry processes. He is almost solely responsible for Chapter 9 and would have written the whole book if I had let him! Eric Balchunas deserves special mention as a friend and supporter. His industry insight is responsible for bringing the implied liquidity function to Bloomberg terminals and enabling the client base to finally have a quantified measure of ETF liquidity.

This book would also not have been possible without the thousands of meaningful conversations I have had with the community of ETF users and traders around the world. I also thank the team at Wiley for making this book a reality. Pamela Van Giessen and I hit it off from our first breakfast together. And Evan Burton and Meg Freeborn have been instrumental in bringing this book from concept to reality.

Lastly, I owe a tremendous debt to my family. I am grateful for the continuing support of my uncle, Howard Abner, throughout my career.

My kids still think writing a book is pretty cool but wish Dad would finish already and ride bikes with them. The fact that my wife doesn’t hate me after this project is a testament to her vast stores of patience and understanding. And Mom, for the thousandth time, the book is coming along fine!


1. Please note the views in this book are my own and do not necessarily represent those of WisdomTree or anyone else.

2. This book was written entirely on an 11-inch Macbook Air.


Characteristics of Modern Investment Products

The world has changed drastically since the turn of the century. Some of the recent changes we have experienced in our lives today are as significant as last century’s introduction of the television or the automobile. The technology revolution is changing and shrinking the world. It’s getting harder to track and enumerate the rapid transformations in many of our daily life activities. If you’ve taken a plane or train recently, you have noticed that most people seem to be interacting and paying attention to a screen. From a train seat, you can read a newspaper, pay your bills, play a game, and even trade and invest on these portable screens. There’s even a good chance you’re reading this book on some form of electronic device.

The Internet and the miniaturization of electronic devices have been disruptive and game changing to many businesses and industries. Where have the stores that sell albums and CDs gone? Where is the Blockbuster video store that used to be on your corner? Banking is another industry that is undergoing its own transformation because of modern technology. Every aspect from commercial banking, I haven’t written a check in years, to investment banking and trading has been affected by technology. Just the way the news is always at our fingertips now, so is our ability to trade and invest.

This is a book about change. The use of exchange-traded funds (ETFs) is a revolutionary change for investors and for those in the investing business. Never before have investors been able to get the transparency, the liquidity, or the access now available in the form of ETFs. ETFs have packaged indices and other forms of asset classes and benchmarks neatly into the palm of your hand. A recent report claims that “ETFs have democratized access to an array of asset classes and strategies.”1 The report further details change in the financial advisory business with ETFs giving advisors the ability to monetize their investment advice by giving them access to almost every asset class in the simplicity of a brokerage account. ETFs give you the power of choice for your asset allocation and modern technology gives you the easy access to implement it.

In this chapter, we’ll take a look at the growth of the ETF market and what the product array looks like. We’ll delve into the characteristics that stand out as unique to ETFs. In addition, we’ll look at the two other major products in the investment landscape that vie for the attention of investors: mutual funds and closed-end funds. It will be valuable to look at the advantages of ETFs, in comparison to other products, to determine how to fit them properly into your own portfolios.

Four Types of Investment Products

According to the Investment Company Institute (ICI), there are four types of products that fit into the definition of investment companies: exchange-traded funds,2 mutual funds (also known as open-end funds), closed-end funds, and unit investment trusts.

Exchange-traded funds are the newest and fastest-growing category, and are the second largest category by assets. ETFs are open-ended investment funds that have a process of issuing or redeeming their shares in blocks, typically 50,000 shares or more based on customer demand. ETFs also have an exchange listing feature that gives investors access to the funds throughout the trading day on public stock exchanges.

Mutual funds are the biggest category of investment products, both by assets and number of available products. They can be either actively managed or designed to passively track an index. They are open-ended funds, meaning that they stand ready to issue new shares or buy back existing shares on a daily basis, typically at their current net asset value (NAV).

Closed-end funds (CEFs) are another type of investment product, but, as the name suggests, they are not open-ended. They issue a limited number of shares once during their initial offering process, and that share amount remains mostly constant throughout the life of the fund. The fund shares trade on an exchange, like an ETF; however, they tend to move to prolonged discounts and premiums, primarily due to the limitations on new share issuance coupled with changes in investor sentiment and demand.

Unit investment trusts (UITs) are a combination of several of these product types. They issue specific amounts of shares that are called units. They trade on exchanges but typically only to facilitate redemption of shares by investors. And the portfolio is typically fixed until a predetermined termination date.

The growth of assets in each product set over the last 15 years tells an interesting story. You can see in Exhibit 1.1 that two types of the products, ETFs and mutual funds, have grown at a very rapid pace. Closed-end funds have grown slowly, and UITs actually represent a smaller amount of assets than they did 15 years ago. The recent rampant pace of growth in the ETF industry is astounding. Overall, the products are still somewhat small in total assets, representing only about 8 percent of the mutual fund industry. However, the rate of asset growth and customer adoption is definitely bringing more and more attention to the newcomer among investment companies.

Exhibit 1.1 Investment Company Total Net Assets (in $billions) by Type

1. ETF data prior to 2001 were provided by Strategic Insight Simfund. ETF data include investment companies not registered under the Investment Company Act of 1940 and exclude ETFs that invest primarily in other ETFs.

2. Mutual fund data include only mutual funds that report statistical information to the Investment Company Institute. The data do not include mutual funds that invest primarily in other mutual funds.

3. Total investment company assets include mutual fund holdings of closed-end funds and ETFs.

Source: Investment Company Institute and Strategic Insight Simfund.


The growth rates tell the story about an investing public that is becoming savvier about its use of investment products and more demanding about the characteristics of those products. The CEF and UIT are examples of products that tend to exhibit less desirable traits, such as higher fees, lower liquidity, and a focus on a small, select group of investors. You can see that assets are subsequently lagging in those categories

As a result of the technology revolution, products are evolving as systems, and regulatory structures develop. The ETF structure, from its creation about 20 years ago, is an example of taking a mutual fund structure and combining it with some of the benefits of the closed-end fund structure to develop a product that provides new and unique benefits to investors. When coupled with the development of stock market infrastructure that facilitates increased electronic access and advanced trading speeds, we have created a fertile climate for an investment product revolution not seen since the early days of mutual funds themselves.

Coincidentally, studies have shown that asset allocation is responsible for a significant portion of portfolio returns. There really is no better tool than the ETF for easy and quick access to a wide swath of asset classes. Let us take a look at some of the main features of ETFs and what I like to call their “cousin” products, the mutual fund and the closed-end fund. This analysis will help explain the rapid growth of this newer investment company product versus its more traditional counterparts.

Exchange-Traded Funds

The growth of assets in exchange-traded products and the development of the ecosystem of businesses around that growth have been stunning in recent years. Numerous factors have contributed to this growth, from the Wall Street marketing engines, to the regulatory changes that provide for significant structural advantages, to the growth of electronic trading. What is rarely mentioned, however, is that investors have simply been demanding a way to invest with reasonably low fees and through a straight-forward structure. The main tranche of the ETF market provides this, along with a level of transparency and other benefits that were unavailable in previous products.

Let’s take a look at the characteristics of this product structure and why it is taking the investment world by storm. In Exhibit 1.1, you were able to see the dramatic asset growth. There are some defining characteristics that are attracting investors to these products, either for new portions of their portfolios or for transitions of their entire investment strategies. The main ones are:

In the following sections, I’ll go through these main characteristics and explain their differences from alternative products.


When transparency is mentioned as a defining characteristic, it sometimes takes a minute of personal product inventory for an investor to realize that there is really no other fund product available that provides a daily accounting of exactly what the fund holds. Before ETFs, portfolio holdings were typically only released on a quarterly or semiannual basis. ETFs make their portfolio publicly available daily. This has a host of ramifications, from eliminating style drift to creating the basis for an arbitrage that keeps the trading price close to fund value. One would have thought transparency should have been the gold standard in investment products from their very beginning, but it does not seem as if investors learned anything from watching the Wizard of Oz!

Regarding the transparency of ETFs, it is important to understand that the majority of assets are in index tracking products. Daily transparency works well for passive index tracking. Conversely, a majority of mutual fund assets are in what are called actively managed funds. These are funds that have a portfolio manager whose intention is to manage the holdings of the fund to perform better than some specified benchmark. A prevalent argument for not disclosing a daily portfolio of an actively managed ETF is a fear that investors would purchase the portfolio themselves instead of putting assets into the fund and paying the manager for their trading ideas for outperformance. That may be true if it was more economical for investors to do that and gain efficiency. It is also feared the disclosure would drive costs to the fund higher because of the front running. In reality, it would probably drive the management fees for those funds lower in order for them to compete. We are already starting to see that happen, and it is slowly squeezing industry margins.


Exchange listing and the variety of asset classes within the ETF structure enable investors to maintain all parts of their investment portfolio in one account with a single set of statements and processes. You can have your commodities exposure with your fixed-income and equities exposures all together, making it easy to understand your performance and view your allocations. All the various asset classes look structurally similar in an equity-style product wrapper.

In addition, portfolio managers of actively managed funds may be concerned about investors backing into their supposedly magical proprietary strategies. I don’t think these concerns outweigh the benefits to clients of knowing what is in a fund portfolio on a daily basis. Currently, there are active ETFs available that are providing baskets daily without announcing changes before they occur. That is working very well as a model, and the assets in those funds are growing rapidly. In essence, I agree with the Blackrock goal of “daily disclosure of holdings and exposures”3 as defined in their recent recommendations on the ETF product set.

Exchange Listing

There is sometimes confusion that exchange listing is all about liquidity, but that is just one of several benefits. The three major positives of exchange listing are:

  1. Standardization

  2. Intraday trading

  3. Liquidity

Standardization is proving to be a tremendous benefit to holding multiasset portfolios all within the same account structure. ETFs neatly package all asset classes into an equity structure that can reside in the simplest of brokerage accounts. This was impossible just a few years ago. Now you are able to keep your bond position wrapped in an ETF structure within your investment account, instead of having your portfolio separated in different account types with attendant complications. You can even include your commodities ETF piece and your alternatives ETF selections in your investment account. Trading in the products also becomes standardized. If you understand how ETFs trade, you’ll be able to trade all the asset classes in your portfolio easily from the same account, probably using the same tools.


The trading of ETFs requires more knowledge than was required when customers were using mutual funds to invest. By becoming your own advocate when trading the products you can create significant execution cost savings. As you will learn about in more detail later in the book, trading the products is unique and is probably the most important nuance that clients need to understand better when building portfolios of ETFs.

Intraday trading of exchange-traded funds has been the characteristic that presents itself as both a blessing and a curse. The mutual fund industry has the benefit of never having to explain to a client the concept of how to achieve best execution. They rarely even have to explain poor trading practices within the performance of a portfolio. While intraday trading adds to the transparency and liquidity of the ETF product class, it puts the responsibility of understanding how to achieve best execution on the investor. The execution portion of the equation is a very important part of the investment process. Every new client has to climb the learning curve of how to achieve a good execution in the products. The ETF industry has given investors the ability to manage their own executions. But with this responsibility there is a learning curve that is proving to be somewhat steeper than the industry may have expected. I’ve been involved in the trading of ETFs for almost 15 years, and I am still answering basic questions about liquidity and trading. Part of that problem is the slowness of systems and processes to adapt to this new necessity. It is critical to become an advocate for yourself and your clients when trading ETFs. Advances in execution when managing a portfolio of ETFs can save millions of dollars annually.

For many investors, the intraday trading aspect of ETFs is not that important, nor should it be. This is why I have broken it out from liquidity as a separate factor. If you are using an investment process that instructs you to buy a fund today, hold it for some extended period based upon various parameters, and then sell it, then trading intraday, except on those execution days, is like a good insurance policy. It is there if you ever need it, but most of the time you won’t. In addition, if you’re trading in ETFs with foreign underlying assets, the intraday trading of a fund in the United States adds an additional dimension and time zone for trading the foreign assets. There are some ETFs that can even be traded 24 hours a day through your broker dealer, which adds a never before seen flexibility to the management of portfolios.


One difference in trading between an ETF and a stock is that an ETF trade is typically between a customer and a liquidity provider. Very rarely are two end customers trading against each other without an intermediary in between. The liquidity providers, or other professional traders, are usually providing liquidity from the basket to the ETF shares for the client, utilizing the arbitrage function that keeps the trading price right around the value of the basket.

As the trading industry evolves to a more process-driven business based around customer service and continues to attract different kinds of liquidity providers, the customer experience in ETFs will continue to improve. Several of the large customer execution providers are offering commission-free ETF trading on many of their platforms. Essentially, we are seeing a full-scale change in the way equities orders are executed because they now include ETFs. ETFs trade differently than stocks, although they share similar characteristics, so the major execution platforms servicing advisors are retooling to understand and achieve better liquidity in the ETFs. In this book, you will read more about this evolution of providing better execution services to all ETF investors, from the growth of liquidity aggregators to agency executions of baskets with an exchange for ETF shares.

Listing a product on an exchange and creating a standardized format provides access to a wider variety of market participants and can increase liquidity and participation to a level that could not have been previously achieved. This has also helped to decrease trading spreads for many products. You can see in the grid in Exhibit 1.2 where the ETF price is actually trading between the bid and ask spread of the underlying basket. Listing on the exchange has brought multiple sources of liquidity into one location creating a tangible benefit for investors.


The in-kind creation and redemption process is what drives some of the tax efficiency of the ETF structure. The portfolio can be managed by the delivery and receipt of shares without trading and causing tax liabilities.

This extreme liquidity injection does not happen in every product but at the very least exchange listing adds to the liquidity base. The trading that takes place in some of the highest-volume ETFs has had the effect of causing the ETF itself to trade at a tighter spread than its underlying basket and in much greater size than would be expected. In Exhibit 1.2, you can see the market price and the indicative value (IV) of the SPDR S&P 500 ETF Trust (SPY). There are many more details about indicative value in Chapter 2.

Exhibit 1.2 SPY Price Spread Example

Reprinted with permission from Bloomberg. Copyright 2012 Bloomberg L.P. All rights reserved.


If you look at the spread column, you can see that the basket is showing an implied ETF spread of 4 cents wide. However, the fund is showing a trading spread of only 1 cent wide. The fund is trading at a tighter spread than would be available if you traded the basket. This anomaly becomes much more pronounced in some products that trade high volumes or have underlying assets that are not readily accessible. The exchange provides a secondary gathering place for a wide variety of market participants that might not have found each other otherwise. The advantages of this become even more evident as products emerge providing access to formerly hard-to-access asset classes. In many cases, the ETF is becoming a vehicle to aid liquidity growth in the underlying basket itself. Bringing together multiple different investor types into one standardized vehicle is centralizing product liquidity as is the purpose of an exchange listed market. As you can see in Exhibit 1.3, the wide array of ETF users all come together in the products on an equal playing field. There are no multiple shares classes or alternative structures for institutions versus smaller investors.


Creation and redemption of ETFs centers around the delivery of baskets of shares in exchange for ETF shares between Authorized Participants (AP) and ETF issuers (AP). This process, described in detail in Chapter 2, is one of the keys to the structure. It is how an ETF grows larger with investor demand and then shrinks when the underlying asset class moves out of favor.

The tighter spreads are also possible because of the arbitrage available when you have two products, the basket and the ETF, that can easily be converted into one another. This is known as being fungible. There is a lot of competition in the trading industry to capture any spread between the ETF price and the basket price. This is advantageous for investors because, as those trading firms compete, they drive spreads ever tighter and keep the ETF trading near its fair value. There are also alternative trading vehicles like futures and options that trade in conjunction with some ETFs and this only further enhances the liquidity pool. For investors, the centralizing of users into the ETFs is very beneficial because the presentation of tighter spreads and more liquidity than had previously existed translates into cheaper execution costs for the end investor.

Exhibit 1.3 ETF Market Participants


Tax Efficiency

I present the basics of why ETFs are different than other investment products in terms of their tax consequences, but I am not a tax attorney or an accountant. Each individual situation is different, and you should consult your own advisors regarding your personal tax situation. I am also discussing the funds in a normal taxable environment. Things can change when the funds are held in tax-deferred accounts and other structures.

The concept of the tax efficiency of the ETF structure is another major feature that is helping to drive growth. In trying to simplify the discussion down to its most important aspects, I have isolated three subcategories:

The major tax advantage of the ETF structure within the portfolio management process derives from the concept of in-kind creation and redemption. I will cover the details of how creation and redemption works in Chapter 2 but for now will explain the differences between ETFs and their mutual and closed-end fund cousins.

When investors add assets to mutual funds, the portfolio managers are taking in cash from the investors and then purchasing the underlying basket of assets. The reverse happens when an investor wants to redeem shares of the mutual fund. At that point, the mutual fund manager has to raise cash to deliver back to the investor. In general, they need to sell assets that the fund holds. This selling of assets typically generates a taxable event for the mutual fund. Funds do hold certain cash reserves to accommodate some redemption, but this can lead to performance lag and so needs to be done sparingly. There are also other minor techniques to manage the portfolio, but at its essence, when investors come into and out of mutual funds, the portfolio managers are buying and selling the underlying assets. This is creating taxable events within the funds that will need to be distributed among the remaining shareholders. Then at some point in the future, depending on the distribution schedule, the mutual fund will make distributions of short- and long-term capital gains that will be taxable events for shareholders.


The ETF industry makes use of two parts of the capital markets: the primary market and the secondary market. The primary market is where issuance takes place. All creations and redemptions are considered to be taking place in the primary market. The secondary market is where previously issued securities trade. When you are trading a stock or ETF on an exchange, you are trading in the secondary market. Do not confuse this with the primary exchange listing of an ETF, which delineates the exchange on which a product was first listed to begin trading and that affects the official opening and closing auction and prices.

The way a typical equity ETF takes in and disburses assets is quite different. It surprises me how many users of ETFs have not gotten a firm grasp on how the ETFs take in assets, unwind assets, and even make money on those assets. The first stage is taking in assets. An ETF transacts on two levels in the markets, the primary market and the secondary market.