My fifteen-year-old son has become obsessed with the show “Jeopardy!,” and every night as my family prepares to eat dinner, I can hear it on the TV in the background. The answer-and-question format has made me think about alternative ways to talk about ETFs. So much of what is said about ETFs still seems to be a clutter of misunderstanding, and I wish more clarity were brought to the conversation. If ETFs were one of the game’s categories, I imagine contestants (investors) could address the issues in the answer-and-question format, and it might even sound something like this (with my added commentary, if I were the show’s host):

I’ll take ETF clarity amid the clutter for $100…

Answer: The Investment Company Act of 1940.
Question: What is the primary legislation regulating mutual funds and ETFs?

That’s right; the vast majority of ETFs are organized and regulated under the “1940 Act,” the same legislation that governs mutual funds. It imposes a host of investor protections, including those related to organizational structure and investment activities. This makes ETFs that are subject to the 1940 Act among the most stringently regulated investment products available in the United States. Since I’m on the topic of regulation, I’d add that from a shareholder’s perspective, taxation of 1940 Act ETFs and mutual funds is the same.

ETF clarity for $200…

Answer: To facilitate diversified access to an investment strategy.
Question: What is the fundamental purpose of an ETF?

While the headlines and general buzz might focus on the intraday trading feature of ETFs, decisions related to product use still begin with investment exposure, asset allocation, and portfolio construction. As it turns out, ETF and mutual fund investors allocate assets similarly. In fact, much of the difference between ETFs and mutual funds isn’t about structure. Instead, the difference is that most ETFs follow index strategies while most mutual funds follow active strategies.

ETF clarity for $300…

Answer: Eighty-three percent.
Question: What is the ratio of bond ETF trading volume conducted on the secondary market?

Speaking of the intraday trading feature, I always hear about the vast volume of ETF trading and the concerns related to underlying market volatility. However, the overwhelming majority of ETF trading volume reflects secondary market transactions (i.e., trading of ETF shares between two market participants), and only a limited amount of this trading volume by market participants results in primary market trading (i.e., trading in the underlying securities market). The graph below shows the percentage of daily bond ETF trading volume conducted solely on the secondary market. The median ratio was 83%, suggesting that for every $1 in trading volume, only $0.17 resulted in primary market trading. Put another way, 83% of the trading volume resulted in no portfolio management impact and no trading in underlying securities.

 

Chart 1

You might be asking why I find the answer-then-question format to be compelling. Well, many times the questions I hear about ETFs contain faulty assumptions. In other words, the questions themselves contain clutter! Stating the answer first is a way to showcase the clarity. Details related to the above—in addition to other points of clarity—can be found in our new commentary. Even though we might not use the answer-and-question format, I think you’ll find it manages to separate the clarity from the clutter.

I would like to thank my colleague Craig Gross for his contributions to this blog.

Notes:

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the loss of principal.