Exchange-traded Funds (ETFs): A strategic tool for diversified investing

What are exchange-traded funds? ETFs are investment companies registered under the Investment Company Act of 1940 as baskets of securities linked to an index. ETFs sell shares at net asset value (NAV), the book value calculated by subtracting liabilities from assets and dividing by shares outstanding. Their shares can be traded, like stocks, on an exchange.

Traditional ETFs: The first ETF was the Standard and Poor’s Deposit Receipt (SPDR, pronounced “spider), created in 1993 to mirror the S&P 500 Index. Traditional ETFs are managed to mirror the holdings and performance of a particular index. History shows that indexing provides more consistent returns for most investors when compared to actively managed open-end funds. Due to their popularity, ETFs have evolved to include sector funds, bond funds, currency funds and even “inverse” funds—funds designed to perform as the inverse of whatever benchmark or index they track.

Actively managed ETFs: In 2008, the U.S. Securities and Exchange Commission authorized the creation of actively managed ETFs. These do not follow any particular index. Rather, their managers pick securities consistent with the ETF’s investment objectives and policies.

Leveraged ETFs: Used by aggressive investors and hedge fund managers seeking to profit from dramatic swings in the market, leveraged ETFs are a very risky type of fund that attempts to achieve returns two or three times the return of a stated index. Karpus Investment Management believes Leveraged ETFs are highly speculative vehicles that should be avoided by long-term investors.
 

What are the advantages of ETFs? Index-mirroring ETFs are attractive to investors because they exhibit low costs, transparency and tax efficiency. They don’t incur many transaction costs, making them cheap compared to mutual funds. (Actively managed ETFs, however, might charge higher fees from passing trading and management costs to investors.) ETFs may be traded intraday at current market prices, bringing trading flexibility. (Mutual funds use end-of-day prices.)
 

How are ETFs bought and sold? ETFs do not sell individual shares directly to investors. They issue shares in large blocks of tens of thousands, called “Creation Units,” to authorized buyers—usually large institutions. The buyers generally purchase Creation Units not with cash, but with a basket of securities that mirrors the ETF’s portfolio. The buyer then often splits up the creation unit and sells individual shares on a secondary market.

How does Karpus Investment Management use ETFs? KIM invests in ETFs as part of its overall investment strategy that emphasizes use of closed-end funds. Like ETFs, closed-end funds contain baskets of securities and trade intraday on the open market. Unlike ETFs, closed-end funds often trade at significant discounts to their net asset value. KIM purchases closed-end funds when discounts are attractive and sells them when discounts narrow, using ETFs as a complementary investments.