An Efficient Approach to Global Asset Allocation - Essay Example

TF country-specific funds are tax-efficient. They are created in kind and redeemed in kind. ETFs shares are bought by market participants by depositing with the fund the index constituents. They are redeemed by investors getting underlying high unrealized capital gain stocks with the fund retaining low unrealized gain stocks. Thus ETF reduces capital gains tax liability as it would not be called upon to sell high capital gain stocks and incur capital gains tax. Open or closed-end funds, on the contrary, redeem in cash and may have to sell high capital gains stocks in order to meet rushed redemption requirements and may end up paying capital gains tax on realized capital gains.

ETF investors can exchange their ETF shares and receive in-kind the underlying shares, or even sell their ETF shares on the stock exchange without getting into selling the underlying shares. This circumvents capital gains tax liability for all investors. For large institutional investors, the ETF's in-kind creation and redemption mechanism soften the market impact which otherwise can be telling when large parcels are traded on market. Third, country-specific ETFs have more tracking precision as compared to conventional closed-end funds because the creation and redemption of ETF shares frequently force arbitrageurs to ensure close tracking and transparency in respect of underlying stocks in the fund.

Fourthly, empirical studies have surmised that country-specific ETFs are cheaper than closed-end country funds with low expense ratios which can go as low as less than half of those experienced by other country closed-end funds. Generally, country-specific ETFs are passively managed and re-balancing is used to keep the investment portfolio closely in line with the relevant index (ETFs, like other index funds, essentially self re-balance, with portfolio changes balancing any corresponding change in the index constituents).

ETFs also do not serve as part of market-timing strategies; therefore, no cash buffers are required and their holdings are not changed during, or in anticipation of, market downturns. The latter avoids the cash drag effect normally associated with funds that keep cash to take care of redemptions. By diversifying internationally using country-specific EFT funds, we eliminate country-specific risk and consequently enhance mean-variance efficiency and returns (Miffre, 2004).