Exchange-traded fund Totally Explained

Everything about Exchange-traded Fund totally explained

An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. An ETF holds assets such as stocks, bonds, or futures. Institutional investors can redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the underlying assets or, alternately, exchange the underlying assets for creation units. This creation and redemption of shares enables institutions to engage in arbitrage and causes the value of the ETF to approximate the net asset value of the underlying assets. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500. An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be purchased or redeemed at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be substantially more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they're funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs.

Structure

ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, ETFs don't sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units." Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets. Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that wouldn't otherwise allow the ETF structure. In 2008, however, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders. Under the SEC proposal, an ETF would be defined as a registered open-end management investment company that:

Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated on a per share basis by a national securities exchange at regular intervals during the trading day;
Identifies itself as an ETF in any sales literature;
Issues shares that are approved for listing and trading on a securities exchange;
Discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and
Either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund. and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on 25 March 2008. The SEC rule proposal indicates that the SEC isn't suggesting that it won't consider future applications for exemptive orders for actively managed ETFs that don't satisfy the proposed rule's transparency requirements.
History
ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.
   A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States. Known as SPDRs or "Spiders", the fund became the largest ETF in the world. Other U.S. ETFs quickly followed based on other broad market indexes.
   Barclays Global Fund Advisors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind. In 1998, State Street Global Advisors introduced the "Sector Spiders," which follow the nine sectors of the S&P 500.
   Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of March 2008, there were 644 ETFs in the U.S., with $571 billion in assets, an increase of $127 billion over the previous twelve months.
Investment uses
ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies.

Lower costs - ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs don't have 12b-1 fees.

Buying and selling flexibility - ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they're willing to trade.

Tax efficiency - ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they don't have to sell securities to meet investor redemptions.

Market exposure and diversification - ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.

Transparency - ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day. Some of these advantages derive from the status of most ETFs as index funds.

Types of ETFs

Index ETFs

Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index. As of February 2008, index ETFs in the United States included 415 domestic equity ETFs, with assets of $350 billion; 160 global/international equity ETFs, with assets of $169 billion; and 53 bond ETFs, with assets of $40 billion.

Commodity ETFs

Commodity ETFs invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. Commodity ETFs generally are index funds, but track non-securities indexes. Because they don't invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.

Actively managed ETFs

Actively managed ETFs are quite recent and have been offered only since 25 March 2008 in the United States. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it's willing to consider allowing actively managed ETFs that are not fully transparent in the future.
The initial actively managed ETFs have received a lukewarm response and have been far less successful at gathering assets than were other novel ETFs. Among the reasons suggested for the initial lack of market interest are the steps required to avoid front-running, the time needed to build performance records, and the failure of actively managed ETFs to give investors new ways to make hard-to-place bets.

Exchange-traded grantor trusts

An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRs, a proprietary Merrill Lynch product. HOLDRs are neither index funds nor actively-managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRs have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRs to be a separate product from ETFs. Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.

Taxation

ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that isn't balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they'd a stock, or effect a non-taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the ETF trades to reflect changes in the underlying index.
In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares.

Trading

Perhaps the most important benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many ETFs have the capability for options (puts and calls) to be written against them. Mutual funds don't offer those features.
   For example, an investor in a mutual fund can only purchase or sell at the end of the day at the mutual fund's closing price. This makes stop-loss orders much less useful for mutual funds, and not all brokers even allow them. An ETF is continually priced throughout the day and therefore isn't subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the ETF for cash throughout regular trading hours, and often after-hours on ECNs. ETF liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid ETFs such as SPDRs can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.
   Another advantage is that ETFs, like closed-end funds, are immune from the market timing problems that have plagued open-end mutual funds. In these timing attacks, investors trade in and out of a mutual fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term shareholders. With an ETF (or closed-end fund) such an operation isn't possible—the underlying assets of the fund are not affected by its trading on the market.
   Investors can profit from the difference in the share values of the underlying assets of the ETF and the trading price of the ETF's shares. ETF shares will trade at a premium to net asset value when demand is high and at a discount to net asset value when demand is low. In effect, the ETF is providing a system for arbitraging value in the market. As the initial costs are one-off, the ETF vehicle offers some cost advantages over other forms of pooled investment vehicles.

Criticism

John C. Bogle, founder of The Vanguard Group, a leading issuer of index funds (and, since Bogle's retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that's held over time can be a good investment.
ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indexes is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indexes.

Major issuers of ETFs

Ameristock issues Ameristock ETFs.

First Trust Advisors issues specialty First Trust ETFs.

Barclays Global Investors issues iShares.

State Street Global Advisors issues streetTRACKS and SPDRs.

Vanguard Group issues Vanguard ETFs, formerly known as VIPERs

Rydex Investments issues Rydex ETFs.

ETF Securities issues ETFs or specialised ETCs

Merrill Lynch issues HOLDRs.

PowerShares issues PowerShares ETFs, as well as BLDRS based on American Depositary Receipts.

Deutsche Bank manages PowerShares DB commodity- and currency-based ETFs.

WisdomTree issues fundamentally weighted WisdomTree ETFs.

Lyxor Asset Management issues Lyxor ETFs.

ETF Capital Management operates a global fund of ETFs.

Claymore Securities issues specialty Claymore ETFs.

ProFunds issues inverse and leveraged ETFs.

Van Eck Global issues Market Vectors ETFs.

AdvisorShares proposes to issue actively managed AdvisorShares ETFs.

RevenueShares issues Revenue-Weighted ETFs

SPA ETFs are fundamentally weighted ETFs.

Jovain Capital has control over BETA-PRO ETFs which are available on the Canadian TSXFurther Information

Get more info on 'Exchange-traded Fund'.

External Link Exchanges

Do you know how hard it is to get a link from a large encyclopaedia? Well we're different and will prove it. To get a link from us just add the following HTML to your site on a relevant page:

<a href="http://exchange-traded_fund.totallyexplained.com">Exchange-traded fund Totally Explained</a>

Then simply click through this link from your web page. Our crawlers will verify your link, extract the title of your web page and instantly add a link back to it. If you like you can remove the words Totally Explained and embed the link in article text.
As long as your link remains in place, we'll keep our link to you right here. Please play fair - our crawlers are watching. Your site must be closely related to this one's topic. Any kind of spamming, dubious practises or removing the link will result in your link from us being dropped and, potentially, your whole site being banned.