Exchange-Traded Fund (ETF) Investment
An Introduction to ETF Investing
Exchange-Traded Fund (ETF) Investment
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Exchange-traded funds (or ETFs) are open ended mutual funds that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (.INX) or the Hang Seng Index, a market sector such as energy or technology, or a commodity such as gold or petroleum; However, as ETFs proliferated in 2006 from under one hundred in number to almost four hundred by the end of the year, the trend has been away from these simpler index-tracking funds to intellidexes and other proprietary groupings of stocks.
The legal structure and makeup varies around the world, however the major common features include:
These qualities provide ETFs with some significant advantages compared with traditional open-ended collective investments. The ETF structure allows for a diversified, low cost, low turnover index investment. This appeals to both institutional and retail investors both for long term holding and for selling short and hedging strategies.
ETFs have been gaining popularity ever since they were introduced on the American Stock Exchange in the mid 1990s, beginning with SPY (launched by State Street Global Advisors and tracking the S&P 500) in 1993. There are now over one hundred ETFs traded on the American Stock Exchange, with more in other countries.
ETFs are attractive to investors because they offer the diversification of mutual funds with the features of a stock. The popularity of these funds is likely to increase as new and more innovative ETFs are introduced.
The original ETFs were set up as competitors to open-ended index funds, and subsequent ETFs have usually followed in their footsteps: they typically have very low expense ratios compared to actively managed mutual funds. They also have a lower turnover ratio, which in some jurisdictions can be more tax-favorable.
ETF managers such as BGI and State Street Global Advisors are the current leaders in the ETF industry by assets under management, with 75% of the market.
Many current U.S. ETFs are based on some index; for example, SPDRs (Standard & Poor's Depository Receipts, or "Spiders") (AMEX: SPY) are based on the S&P 500 index. The index is generally determined by an independent company; for example, Spiders are run by State Street, while the S&P 500 is calculated by Standard & Poor's. Sometimes, a proprietary index is used.
Although the Securities and Exchange Commission (SEC) states that an ETF is "a type of investment company whose investment objective is to achieve the same return as a particular market index," this is no longer reality. The development of investment structures has progressed more quickly than the SEC's website.
A series of ETFs introduced by ProShares in 2006 - 2007 no longer follow the traditional definition. These funds, while correlating to the performance of the S&P 500, NASDAQ 100, DJIA, and S&P 400 Midcap, do not attempt to merely achieve the same return as the underlying index. These forty funds attempt to either achieve the daily performance of the designated benchmark times two, times negative one, or times negative two. They are ETFs with integrated leverage.
Another example of an innovative ETF that has broken the classic mold is the oil futures ETF: USO. This ETF tracks the performance of the Western Texas Intermediate light sweet crude. This is not a benchmark, but a traded commodity.
Rydex has taken a different direction and worked with S&P to create new, equal-weight benchmarks for their proprietary benchmarks. These "benchmarks" are rebalanced quarterly.
Creation and redemption of shares
Rather than the fund manager dealing directly with shareholders, parties who have entered into a contract with the fund, such as institutional investors, and called Authorized Participants (APs) will create a basket of shares replicating or approximating the index, and deliver them to the fund in exchange for ETF shares. A basket, or creation unit, consists of anywhere from 10,000 ETF shares to 600,000 ETF shares.
ETF shares are then sold and resold freely among investors on the open market. If an investor accumulates a sufficient amount of ETF shares, he can exchange one full creation unit of ETF shares for a basket of the underlying shares of stock. The ETF creation unit is then redeemed and the underlying stocks are delivered out of the fund.
One of the advantages of this creation / redemption method for the fund investors is that institutional investors cover the dealing costs in purchasing the required shares to make up the portfolio. One of the reasons they are willing to do this is that they can profit by arbitrage based on the trading price of shares on the secondary market. Shares will trade at a premium to net asset value if demand is high and at a discount to net asset value if demand is low. These market drivers provide the efficiency for the ETF managers as the bulk buying power of the institutional investors allows them to avoid the expense of mass share creation and deletion.