The Investor's Shelf — one book
The Exchange-Traded Funds Manual

The Exchange-Traded Funds Manual

Gary L. Gastineau
2002
T4 401 pages · about 6h 41m to read OL2787837Wgoodreads

Summary

Gastineau, who was involved in exchange-traded fund development at the American Stock Exchange, wrote the standard technical reference on how these instruments actually work.

The mechanical content is the substance. The creation and redemption process, in which authorised participants deliver or receive a basket of underlying securities in exchange for large blocks of fund shares, is what keeps the fund's market price close to its net asset value, and Gastineau explains why this arbitrage works and under what conditions it breaks. He covers the tax consequences of in-kind redemption, which allows an exchange-traded fund to dispose of low-basis securities without realising gains for continuing holders, and which is the structural tax advantage over mutual funds in the United States.

He also covers the regulatory history and the exemptive relief each structure required, the differences between unit investment trusts, open-end structures and grantor trusts, the trading costs and spreads that determine an investor's real cost, the index licensing arrangements, and the specific problems with fixed income and international products where the underlying does not trade when the fund does.

Gastineau is critical of index construction and of the reconstitution effect, arguing that funds tracking published indices are forced to trade at times when everyone knows they must, which costs holders measurably. He proposed alternatives.

The book is from 2002 and the product set has expanded enormously since, including leveraged, inverse, actively managed and thematic products the book does not cover. The mechanics it explains are unchanged.

Key takeaways 7

  1. The creation and redemption mechanism, in which authorised participants exchange baskets of securities for fund shares, is what keeps market price close to net asset value.
  2. In-kind redemption allows an exchange-traded fund to dispose of low-basis securities without realising taxable gains for continuing holders.
  3. An investor's real cost includes the trading spread and any premium or discount to net asset value, not only the expense ratio.
  4. Funds tracking published indices must trade at reconstitution dates that every other participant knows in advance, which costs holders measurably.
  5. Fixed income and international products face a structural problem because the underlying securities do not trade during the hours the fund does.
  6. The arbitrage that holds price to value depends on authorised participants being able and willing to transact, which is not guaranteed in a dislocation.
  7. Different legal structures including unit investment trusts, open-end funds and grantor trusts have different consequences for dividends, lending and tax.

Who should read it

Investors and allocators who need to understand exchange-traded fund mechanics, tax treatment and the conditions under which the arbitrage holds.

Where it sits in the reference 2

Assets
Styles

Who recommended it 1 · 1 direct

Chai with Pabrai bookshelf — Investing and Capital Allocation

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