Key Takeaways
- ETFs trade on exchanges throughout the day at market prices, not just once daily like mutual funds.
- ETF prices may differ from NAV - trading at a premium (above NAV) or discount (below NAV).
- Authorized Participants (APs) keep ETF prices aligned with NAV through arbitrage.
- ETFs are generally more tax-efficient than mutual funds due to in-kind creation/redemption.
- UITs have FIXED portfolios that do NOT change over the trust's life.
- UITs have a set maturity date; mutual funds and ETFs do not.
- Leveraged ETFs reset DAILY and are NOT suitable for long-term buy-and-hold strategies.
- Inverse ETFs profit when the underlying index declines.
ETFs and Unit Investment Trusts
Exchange-Traded Funds (ETFs) and Unit Investment Trusts (UITs) are alternatives to mutual funds with distinct characteristics.
Exchange-Traded Funds (ETFs)
ETFs combine features of mutual funds and individual stocks, offering diversification with intraday trading flexibility.
ETF vs. Mutual Fund Comparison
| Feature | ETF | Mutual Fund |
|---|---|---|
| Trading | Throughout the day on exchanges | Once daily at 4:00 PM NAV |
| Pricing | Market price (may differ from NAV) | NAV only |
| Order Types | Market, limit, stop orders | Market orders only |
| Minimum Investment | One share | May have minimums ($1,000+) |
| Expense Ratios | Generally lower | Generally higher |
| Tax Efficiency | More efficient | Less efficient |
| Commissions | Brokerage commissions | None (no-load) or loads |
| Short Selling | Allowed | Not allowed |
| Margin | Allowed | Not allowed |
Premium and Discount
ETFs can trade at prices different from their Net Asset Value:
| Situation | Definition | Implication |
|---|---|---|
| Premium | Market Price > NAV | Buying above intrinsic value |
| Discount | Market Price < NAV | Buying below intrinsic value |
| At NAV | Market Price = NAV | Fair value |
Authorized Participants and Arbitrage
Authorized Participants (APs) are market makers approved by the ETF issuer to create or redeem ETF shares.
The Creation/Redemption Process
| Process | What Happens |
|---|---|
| Creation | AP delivers basket of underlying securities to ETF; receives creation units (typically 25,000-50,000 shares) |
| Redemption | AP delivers ETF shares to issuer; receives underlying securities |
Why This Matters
| Benefit | Explanation |
|---|---|
| Price Alignment | Arbitrage keeps ETF price close to NAV |
| Tax Efficiency | In-kind transfers avoid taxable events |
| Lower Costs | Transaction costs borne by APs, not fund |
Arbitrage Example:
- If ETF trades at a premium: APs create new shares (sell ETF, buy underlying) → increases supply → price falls toward NAV
- If ETF trades at a discount: APs redeem shares (buy ETF, sell underlying) → decreases supply → price rises toward NAV
Exam Tip: The creation/redemption mechanism is why ETFs are more TAX-EFFICIENT than mutual funds. Securities are exchanged in-kind, not sold for cash.
Types of ETFs
| Type | Description | Example |
|---|---|---|
| Index ETFs | Track market indexes | S&P 500 ETF |
| Sector ETFs | Focus on specific industries | Technology ETF |
| Bond ETFs | Hold fixed income securities | Treasury Bond ETF |
| Commodity ETFs | Track commodity prices | Gold ETF |
| International ETFs | Foreign market exposure | Emerging Markets ETF |
| Leveraged ETFs | Amplified daily returns | 2x S&P 500 ETF |
| Inverse ETFs | Profit when markets decline | -1x S&P 500 ETF |
Leveraged and Inverse ETFs
These complex products require special understanding:
| Feature | Leveraged ETF | Inverse ETF |
|---|---|---|
| Goal | Multiply daily returns (2x, 3x) | Opposite of daily returns |
| Reset | Daily | Daily |
| Suitable For | Short-term trading only | Short-term trading only |
| NOT Suitable For | Long-term buy-and-hold | Long-term buy-and-hold |
Daily Reset Problem
Leveraged ETFs reset daily, which causes compounding effects that can significantly differ from expected returns over longer periods.
Example: Index rises 10% then falls 10%
| Investment | Day 1 | Day 2 | Net Result |
|---|---|---|---|
| Index: 100 | +10% → 110 | -10% → 99 | -1% |
| 2x ETF: 100 | +20% → 120 | -20% → 96 | -4% |
| 3x ETF: 100 | +30% → 130 | -30% → 91 | -9% |
Exam Tip: Leveraged and inverse ETFs are for DAILY trading ONLY. They reset daily and should NOT be held long-term. This is a common exam topic.
Unit Investment Trusts (UITs)
UITs are investment companies with fixed portfolios and set maturity dates.
UIT Characteristics
| Feature | Description |
|---|---|
| Portfolio | Fixed at creation - securities do NOT change |
| Management | No active management after creation |
| Maturity Date | Set termination date |
| Sales Charge | Front-end load |
| Expenses | Lower than mutual funds (no management fee) |
| Distributions | Pass through all income to unit holders |
How UITs Work
- Sponsor creates trust with fixed portfolio
- Units sold to investors at Public Offering Price
- Portfolio remains unchanged (no trading)
- At maturity, securities sold and proceeds distributed
- Unit holders can redeem before maturity at NAV
Comparison: Mutual Fund vs. ETF vs. UIT
| Factor | Mutual Fund | ETF | UIT |
|---|---|---|---|
| Management | Active or passive | Usually passive | None (fixed) |
| Trading | End of day at NAV | Intraday on exchange | Through sponsor |
| Maturity | Perpetual | Perpetual | Fixed date |
| Portfolio Changes | Yes | Yes | No |
| Expenses | Higher | Lower | Lowest |
| Sales Charges | Front/back-end loads | Commissions | Front-end load |
Exam Tip: UITs have FIXED portfolios that don't change and have a SET maturity date. This is different from mutual funds and ETFs which continue indefinitely.
Which of the following is TRUE about ETFs?
What is the primary function of Authorized Participants in the ETF market?
A leveraged 2x ETF is designed to:
Which characteristic distinguishes a UIT from a mutual fund?
4.3 REITs and Direct Participation Programs
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