Reading 2022-03-30


Notes from reading

How does ETF provider make money from running an ETF? or What is ETF business model?

The main way ETF providers benefit from running the ETF is through

  • their management fee
  • lending underlying assets/securities of an ETF, or the ETF units itself 1

The management fee is taken out of the NAV and this goes to cover all relevant costs involved with managing the ETF, which consist of things like custodian fees, accounting fees, audit fees and index licencing fees, along with salaries, marketing and office space.

What happens if the ETF provider falls over?

ETF providers must hold each of their fund’s assets in separate trusts, so each individual fund should be protected from creditors if the provider fails. The provider is also required to appoint an independent custodian for each fund, who holds the assets in the fund for the benefit of the unit holders.

In the case of an ETF, the assets are kept safe through a combination of measures:

  1. All ETFs are issued using a unit trust structure;
  2. The assets of the unit trust are owned by the trustee, which can only use them for the benefit of unit holders as permitted by the ETF’s constitution and product disclosure statement;
  3. The ETF units give each unit holder an ownership share in the assets of the ETF as a whole;
  4. For further investor protection, the ETF assets are commonly held by a separate custodian, providing an extra layer of protection.

What happens if the ETF itself closes down?

As with any fund, sometimes the ETF provider may decide to close the ETF. This could happen because the ETF provider isn’t making enough money to reasonably cover the cost of running the ETF.

If investors don’t sell their units in the ETF through their brokerage account prior to the termination date, they will receive a cash distribution equivalent to the NAV on the termination date to their nominated bank account.

How do ETFs works

A physical ETF is an open-ended fund that owns the underlying assets relative to the index it’s tracking and divides ownership of the assets into shares, that investors can purchase on the Stock Exchange by going directly through their broker.


The ETF provider (e.g. Vanguard, BetaShares) will create the fund and generally employ a third-party entity to be the market maker for the fund. The market maker makes new ETF units based on the share prices of the companies the ETF invests in.

  • Market makers create and redeem ETF units in the fund to ensure the price tracks the NAV
  • Market makers buy and sell the underlying securities in the fund to facilitate the order
  • As the fund is open-ended, market makers can continue issuing and redeeming units at price based on the NAV, on an ongoing basis, and generally, make money from the bid/ask spread (which should be reasonable in relation to the transaction costs)
    • Because the market maker is always around to sell ETF units at a fair price, there's little opportunity for other sellers to sell the units for more than they're worth. If someone tries, you can just ignore their offer and buy the cheaper unit directly from the market maker, kind of like buying wholesale.

Companies pay dividends send the money to the ETF issuer. It's the responsibility of the issuer to ensure you get the right amount of dividends and that you pay tax on them. When the dividends get paid to you, the issuer declares what type of dividend it is so your broker can easily deduct your tax.

Like shares, ETFs make money through dividends or when you sell the units at a higher price than you paid for it.

Investing strategies of ETFs

ETFs can follow passive, active or smart beta strategies.

  • Passive investing: Aims to match the returns of a benchmark index
  • Active investing: Aims to outperform the market using a fund manager’s research and philosophy to select investments.
  • Smart beta investing: Aims to outperform the market in specific scenarios using rules or methodology in the form of fixed selection and eligibility criteria. It still tracks a benchmark or index but in a more tailored format

Replication method of ETFs

There are two ways for passive ETFs to track an index or benchmark

  • Physical replication: invests in the securities or assets of the index or benchmark
    • Full replication holds all securities in the exact same proportion, for example all 300 companies from the S&P/ASX 300
    • Sampling replication holds a sample of the securities, which can be more cost-effective for indices with numerous constituents or where the top holdings represent most of the portfolio
  • Synthetic replication: aims to replicate the index or benchmark performance by holding derivatives rather than the underlying securities, usually in the form of swap agreements

Risks of ETFs

  1. Tracking difference

    • While ETFs aim to track a particular benchmark index, the structure and costs of the ETF may mean its performance varies from this
  2. Operational risk

    • The risk that day to day operations of an ETF may be disrupted by operational issues such as a systems failure
  3. Trading away from net asset value (NAV) - bid/ask spread

    • In some circumstances, the price of units in an ETF may trade at a discount or premium to its NAV
  4. Market risk

    • As ETFs replicate the price movements of their underlying index or benchmark, their performance is directly affected by the volatility of these underlying markets
  5. Company-specific risk

    • Changes in a company’s products or financial position could negatively impact its stock price. This can be mitigated through diversification and holding assets that are uncorrelated
  6. Counterparty risk

    • When using synthetic replication, if a counterparty defaults on its obligations under the swap agreement, it is unlikely they will provide the agreed return, which may potentially expose investors to losses
  7. Liquidity risk

    • Some ETFs invest in assets that are not liquid, like emerging market debt. At times, this can make it difficult to trade
  8. Economic risk

    • The volatility of the market can be directly related to economic factors that are outside of the control of the fund. Investors should be aware that outside economic factors can directly affect the performance of their investment

ETFs vs Shares


An ETF invests in a number of different companies. The shares of all the companies are packaged together and sold in one unit. Like a fruit salad, you buy one thing, but you actually get a delicious mix of things inside. You can sell your ETF share at a higher price than you paid for it, just like an ordinary share.

When the companies that the ETF invests in pay dividends, they send the cash to the ETF provider. It's the providers job to pass the dividends on to you or to reinvest them, in the case of total return ETFs.

How ETFs is different to shares

the share price can be influenced by everything from politics and economics all the way down to short-term supply and demand for the share

In the case of ETFs, the price is determined by the share prices of the companies the ETF invests in.

Since supply and demand doesn't apply to ETFs in the same way they apply to ordinary shares, an ETF's share price can go up when a single big share gets more expensive or when all the shares get more expensive. That's why ETF prices reflect the price movement of the market it invests in.

ETF vs mutual fund

ETFs have fewer "taxable events" than mutual funds

  • From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income
  • However, ETFs are structured in such a manner that taxes are minimized for the holder of the ETF and the ultimate tax bill (after the ETF is sold and capital gains tax is incurred) is less than what the investor would have paid with a similarly structured mutual fund.

An ETF is more tax-efficient than a mutual fund because most buying and selling occur through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower.

In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund. Currently (2022), this rule is not applicable to mutual funds' holder in Vietnam market (read here)

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