We’ve already seen how the creation/redemption mechanism helps ensure that ETFs are cheaper, fairer and more dynamic than mutual funds. We’ve also seen why it allows ETFs to keep from trading above or below their NAVs the way closed-end funds do routinely.
But the creation/redemption mechanism drives other benefits as well, helping to make ETFs more transparent and more tax efficient than competing products.
One of the key benefits of ETFs is that they offer better transparency into their holdings than competing mutual funds. With trust in Wall Street at an all-time low, the ability to verify your positions on a daily basis is a big plus.
By law and by custom, mutual funds are only required to disclose their portfolios on a quarterly or semiannual basis—and then only with a 30-day lag. In between reporting periods, investors have no idea if the mutual fund is invested according to its prospectus, or if the manager has taken on unwanted risks. Funds can and do stray from their described targets—a phenomenon known as “style drift”—which can negatively impact an investor’s asset allocation plan.
In short, when you buy a mutual fund, you’re taking a leap of faith—and in the past, investors have been burned.
ETFs are far more transparent. By custom, most ETFs disclose their full portfolios on public, free Web sites every single day of the year. If you go to www.ishares.com, for instance, you can find the complete holdings of almost every ETF in the world. That’s true of most ETF providers.
Some ETFs, such as Vanguard’s products, fall short of this ideal metric. There is no law requiring ETFs to disclose their full portfolios every day.
But there is a rule that requires ETFs to disclose their creation/redemption baskets, which hold the securities that APs must purchase to create new shares of the ETF. This—combined with the ability to see the full holdings of the index an ETF is aiming to track—provides an extremely high level of disclosure even for those few ETFs that fall short of the daily-disclosure ideal.
Of note: All “actively managed” ETFs must by law disclose their full portfolios every day. They are the most transparent of all ETFs.
Greater Tax Efficiency
Both mutual funds and ETFs are required by law to pay out any capital gains they accrue. Capital gains usually result either when the fund has sold securities for a tactical move; or when investors ask for redemptions, and the fund must sell some securities to raise the necessary cash.
ETFs sidestep both scenarios. For starters, because they're index funds, most ETFs have very little turnover and thus amass far fewer capital gains than an actively managed mutual fund would.
But also, when an AP redeems shares, the ETF provider doesn’t have to sell stocks on the open market. He or she simply pays the AP by delivering the underlying holdings of the ETF itself. No sale means no capital gains.
In fact, the ETF provider can even pick and choose which shares to give to the AP—meaning he or she can hand off the shares with the lowest possible tax basis. This leaves the ETF provider with only shares purchased at or even above the current market price, thus reducing the fund's tax burden and ultimately resulting in higher after-tax returns for investors.
>> NEXT UP: WHAT ETFs EXIST?