An Introduction to Mutual Funds, ETFs, REITs, ETNs

MFs, ETFs, REITs, ETNs. Four acronyms many investors may be familiar with, and in their expanded form, they are familiar to many members of the noninvesting public. Mutual funds, born in their modern form in the early 20^th century, enable ordinary investors to diversify their portfolios without incurring excessive transaction fees. Exchange-traded funds (ETFs) are quite similar to mutual funds, offering similar benefits to the consumer. There are structural and trading differences between them, though.

Real Estate Investment Trusts (REITs) are funds in the sense of “pooling together resources”, but they are focused solely on real estate. In fact, they must source 75% of their income from real estate and they must also invest 75% of their assets into real estate ventures, as laid out in this London Stock Exchange guide to becoming a REIT (under Section 3). Interestingly, that means 25% of business can derive from other sources of income, either used for diversification or services related to the REIT (apartment cleaning services are one example).

Exchange Traded Notes (ETNs) are rather new, the first one having been launched in 2006. They are not funds but they have similar characteristics. ETNs are technically uncollateralized debt securities, backed solely by their issuer’s creditworthiness. These issuers are usually big banks and financial institutions. We are including them in this article because a very common use of ETNs is to track indices and other baskets of assets, similar to many ETFs and MFs.

ETNs are relatively speculative when compared to the others in this list, and they’re mostly meant for sophisticated traders. Recently, however, the cryptocurrency craze has led to the creation of cryptocurrency-tracking ETNs. It seems somewhat likely, then, that their popularity will grow among the general public.

Why use Funds?

The main advantage of investing in funds is diversification and exposure without the insurmountable costs of such an endeavour. For an illustration, consider an ETF that tracks the SP500. In order to properly track the index, an individual investor would need to buy at least one share of 500 different companies. Assuming a relatively modest commission of £4 per trade, that would amount to £2000 solely for trading costs. That doesn’t even take into account the capital outlay required to buy the shares themselves.

Further, 500 of the largest American companies may be somewhat simple for many investors around the world to trade. The same goes for the UK and European stocks. But what if a UK resident wanted to invest in Bolivian silver mines? Or an American wants to invest in West African securities? These are not as easy to obtain for the average investor. But for the funds, who have millions or even billions of dollars under management, access is much easier. Therefore, it is easier to gain exposure to foreign and exotic investments without being charged exorbitantly high fees.

ETFs and MFs both have these advantages, and there are equity, bond, commodity, and index products available. For Real Estate Investment Trusts, investors can gain exposure to foreign real estate, too. But many investors are simply interested in the opportunities closer to home. Apartment buildings and housing complexes are expensive, and they are simply out of reach for the average citizen. But a standardized and tradeable security that offers exposure to apartment buildings and housing complex revenues? That’s easy to obtain and much less expensive. REITs, therefore, fulfill the same need as MFs and ETFs, except the underlying is real estate revenue rather than commodities or stocks or bonds.

Why use ETNs?

One of the predominant reasons for investing via funds is broad exposure. Another way to gain exposure to broad indices or asset classes without direct investment is buying an ETN. As mentioned above, they are debt securities, not shares representative of a larger pool (like funds), and they are zero-coupon debt instruments (they pay no interest). The maturity price is based on the underlying indicator (usually an index), but these maturities are years into the future (like any long-term bond).

The most attractive feature of an ETN is its tradeability. It is traded on the open market, just like a stock. Hence the name Exchange-Traded Note as well as the occasional confusion that ETNs are stocks (they’re not). This means the price fluctuates throughout the day, and normally it takes the underlying index’s price.

Another attractive feature is the guaranteeing nature of debt securities. ETFs and Mutual Funds pay investors either dividends or the amount the share is worth. ETNs will usually pay a premium to the market, and therefore the return is guaranteed to be at least the premium paid (the price can certainly fall below the current price, wiping out that guaranteed return).

One side effect of this contracted premium is no tracking error. Funds can sometimes miss their investment goals because their target is not a real asset and they must replicate the target, but volatile markets can lead to tracking error, where the returns on the fund decouple from the underlying. With ETNs, there is no replication needed, because the issuer is promising to pay the premium, not investing the funds directly into the underlying assets.

And finally, ETNs, as debt instruments, allow trading on rather exotic ideas. ETNs do not necessarily need to maintain a portfolio because their cash inflows are meant as a loan to the bond-issuer, while cash inflows at MFs and ETFs are generally meant for expanding the underlying portfolio. This open-use of incoming cash means anything that can be quantified could theoretically be used as the base for an ETN payout. ETFs can become exotic, but they always have to be able to purchase something for their portfolio. MFs tend to be even less exotic than ETFs.

How ETFs and MFs work, their differences, and benefits

ETFs and Mutual Funds are quite similar in a lot of ways. They both provide exposure to broad or inaccessible markets, cut transaction costs for the investors, and provide the benefits of diversification. They are also both open-ended funds, though ETFs appear closed-ended to the average investor.

ETFs and MFs buy an underlying basket of securities, either a physical asset class like equities and commodities or a non-physical class like derivatives. The investors pay for shares in the fund, and the money is invested by purchasing more of the basket assets. As investors enter or exit the fund, there number of shares changes, and therefore MFs and ETFs are considered dynamic: the number of shares is not fixed because more investors – means more money in the portfolio which needs to be invested.

Funds will track a NAV, or Net Asset Value. The underlying portfolio determines the NAV, and in turn, the share price is based on NAV. The NAV is calculated once per day after the end of trading. If more investors enter the market and the portfolio grows but the number of shares doesn’t, then the share price will rise simply when new investors enter the pool. That causes a disconnect between NAV and the share price. Not only is this basically a Ponzi scheme, it shouldn’t be how funds work. So, when the fund’s assets rise, i.e., new investors enter the pool, shares are dynamically created such that the share price remains steady even as the fund pool grows.

The creation and destruction of shares and by whom is where ETFs and MFs differ. The first difference manifests in who buys and sells the shares. For MFs, individuals buy shares through a broker. When the shares are bought, the money is transmitted to the broker, who subsequently forwards the money, less fees, to the fund. When the shares are redeemed (sold), the MF must liquidate part of its portfolio and send the money back to the individual. When the money is removed from the pool, assets and NAV fall accordingly, and shares are dynamically destroyed to ensure a consistent share price. Because of this buying and selling through brokers to funds, MF shares are only purchasable and redeemable after the close of the trading day.

ETF shares, on the other hand, are tradeable at any time. They are traded openly on the exchange. This has a couple important consequences. First, ETFs have an Intraday Indicative Value (IIV), which tracks the value of the underlying portfolio throughout the day. It is analogous to a real-time NAV. Importantly, this IIV (and the NAV) can differ from the share price, because ETF share prices are determined by supply and demand, not the NAV, like MFs.

Second, the number of ETF shares doesn’t change when investors buy or sell. With MFs, the money goes directly to the fund, and the fund’s assets under management (AUM) increases. For ETFs, the money goes to whoever held the shares last, which means it goes to another investor on the secondary market, not to the ETF’s AUM. The bridge between the average investor and the fund is the authorized participant, who can buy blocks of shares from the ETF and sell them on the open market. Authorized participants can also redeem shares. This bridge causes the price to closely mirror the IIV and NAV, because authorized participants will quickly close the arbitrage opportunities. These blocks are normally 50,000 shares, so retail investors are not involved.

Types of Investment Goals of ETFs and MFs

There are several types of ETFs and MFs available. This section is not about asset classes tracked by funds but the ways in which funds are managed and their investment goals.

The physical funds purchase their underlying assets directly, holding them in whatever weighting they deem necessary to achieve their goals. Synthetic funds hold derivatives to achieve their benchmark. Options and swaps are common holdings for synthetic ETFs.

In the United States, the SEC has disallowed new synthetic ETFs from any market participant. The only participants approved for new synthetic ETF issues are funds that already had experience with them, and the market share of synthetics has consequently shrunk. Europe continues to see the switch from synthetic ETFs to physical ETFs as well, with many firms opting to use physical replication in place of derivatives.

However, leveraged and inverse ETFs still require some derivative usage. They represent a small portion of funds, both in terms of the number of products and in assets under management, but they are still around.

Another interesting type of fund is the target date fund. The main purpose of these funds is for retirement planning. As one gets older, s/he tends to become risk-averse. An older investor also has less time to recoup losses, so s/he is less aggressive to protect against losses. Target date funds mirror this behaviour by gradually shifting their holdings from higher-volatility equities into lower-volatility fixed income securities.

An important note about leveraged and inverse funds: leveraged and inverse funds tend to aim for a single day’s return as their benchmark. That means daily losses and gains are amplified or inverted, not other timeframes. At first glance, it may seem that daily amplification would flow over into other timeframes, but that is not true. This chart quite clearly demonstrates the difference for a 2x ETF:

If the daily change flowed over to any timeframe, we should have the same price on Day 5 as Day 1, since the index is back to its original price. After all, a movement of zero leveraged by any amount will still result in zero change. The initial price change will always match over a single day, but then the differences are compounded by the leveraged rate.

The benefits of using funds, ETFs, ETNs, and REITs, at most times, will outweigh the costs associated with transacting and holding them.  You can also let professionals and the market do the work instead of you trying to cherry pick stocks and other financial assets.

Our next instalment will look at ETNs and REITs in more depth, determining how they are different from ETFs and MFs. The third part will discuss how to evaluate ETFs and MFs, deciding which is right for you.