Exchange-traded fund
Encyclopedia
An exchange-traded fund is an investment fund traded on stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...

s, much like stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

s. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...

 over the course of the trading day. Most ETFs track an index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....

, such as the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...

 or MSCI EAFE
MSCI EAFE
The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada...

. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. ETFs are the most popular type of exchange-traded product
Exchange-traded product
An exchange-traded product is a derivatively-priced security which trades intra-day on a national stock exchange. ETPs are typically benchmarked to indices, stocks, commodities, or may be actively managed...

.

Only so-called authorized participants (typically, large institutional investor
Institutional investor
Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets...

s) actually buy or sell shares of an ETF directly from or to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind
Payment in kind
Payment in kind refers to payment for goods or services with a medium other than legal tender ....

 with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but usually act as market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...

s on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...

 of the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market
Secondary market
The page applies to the finanical term; For the merchandising concept, see Aftermarket .The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold....

.

An ETF combines the valuation feature of a mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...

 or unit investment trust
Unit Investment Trust
A Unit Investment Trust is a US investment company offering a fixed portfolio of securities having a definite life. UITs are assembled by a sponsor and sold through brokers to investors.-Types:...

, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund
Closed-end fund
A closed-end fund is a collective investment scheme with a limited number of shares. It is called a closed-end fund because new shares are rarely issued once the fund has launched, and because shares are not normally redeemable for cash or securities until the fund liquidates.Typically an...

, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be "ETFs", even though they are 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 fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...

s, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...

 ETFs.

Structure

ETFs offer public investors an undivided interest in a pool of securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

 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 do not 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
Payment in kind
Payment in kind refers to payment for goods or services with a medium other than legal tender ....

, 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.

The ability to purchase and redeem creation units gives ETFs an arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...

 mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.

If there is strong investor demand for an ETF, its share price will (temporarily) rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF and its shares trade at a discount from net asset value.

In the United States, most ETFs are structured as open-end management investment companies (the same structure used by mutual funds and money market funds), although a few ETFs, including some of the largest ones, are structured as unit investment trusts. ETFs structured as open-end funds have greater flexibility in constructing a portfolio and are not prohibited from participating in securities lending
Securities lending
In finance, securities lending or stock lending refers to the lending of securities by one party to another. The terms of the loan will be governed by a "Securities Lending Agreement", which requires that the borrower provides the lender with collateral, in the form of cash, government securities,...

 programs or from using futures and options in achieving their investment objectives.

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
Investment Company Act of 1940
The Investment Company Act of 1940 is an act of Congress. It was passed as a United States Public Law on August 22, 1940, and is codified at through . Along with the Securities Exchange Act of 1934 and Investment Advisers Act of 1940, and extensive rules issued by the Securities and Exchange...

 that would not 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 per share 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.


The SEC rule proposal would allow ETFs either to be index funds or to be fully transparent actively managed funds. Historically, all ETFs in the United States have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares
PowerShares
Powershares refers to a family of exchange traded funds created in 2002 to use quantitative indices as a benchmark for ETFs....

 Actively Managed Exchange-Traded Fund Trust, 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
American Stock Exchange
NYSE Amex Equities, formerly known as the American Stock Exchange is an American stock exchange situated in New York. AMEX was a mutual organization, owned by its members. Until 1953, it was known as the New York Curb Exchange. On January 17, 2008, NYSE Euronext announced it would acquire the...

 under the
symbol YYY on 25 March 2008. The SEC rule proposal indicates that the SEC may still consider future applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rule's transparency requirements.

Some ETFs invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not "investment companies" under the Investment Company Act of 1940.

Publicly traded grantor trusts, such as Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...

's HOLDRs securities, are sometimes considered to be ETFs, although they lack many of the characteristics of other ETFs. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not "investment companies" under the Investment Company Act of 1940.

As of 2009, there were approximately 1,500 exchange-traded funds traded on US exchanges. This count uses the wider definition of ETF, including HOLDRs and closed-end fund
Closed-end fund
A closed-end fund is a collective investment scheme with a limited number of shares. It is called a closed-end fund because new shares are rarely issued once the fund has launched, and because shares are not normally redeemable for cash or securities until the fund liquidates.Typically an...

s.

History

ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...

 proxy that traded on the American Stock Exchange
American Stock Exchange
NYSE Amex Equities, formerly known as the American Stock Exchange is an American stock exchange situated in New York. AMEX was a mutual organization, owned by its members. Until 1953, it was known as the New York Curb Exchange. On January 17, 2008, NYSE Euronext announced it would acquire the...

 and the Philadelphia Stock Exchange
Philadelphia Stock Exchange
Philadelphia Stock Exchange , now known as NASDAQ OMX PHLX, is the oldest stock exchange in the United States, founded in 1790. It is now owned by NASDAQ OMX and located at 1900 Market Street, in Center City Philadelphia.-History:...

. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...

 was successful in stopping sales in the United States.

A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange
Toronto Stock Exchange
Toronto Stock Exchange is the largest stock exchange in Canada, the third largest in North America and the seventh largest in the world by market capitalisation. Based in Canada's largest city, Toronto, it is owned by and operated as a subsidiary of the TMX Group for the trading of senior equities...

 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.

Nathan Most and Steven Bloom, executives with the exchange, designed and developed Standard & Poor's Depositary Receipts
Standard & Poor's Depositary Receipts
The Standard & Poor's Depositary Receipts were launched by Boston asset manager SSgA State Street Global Advisors on January 29, 1993 as the first exchange-traded fund in the United States ; and are part of the SPDRs ETF chain.Designed and developed by American Stock Exchange executives Nathan Most...

 , which were introduced in January 1993. Known as SPDRs or "Spiders", the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs .

Barclays Global Investors, a subsidiary of Barclays plc
Barclays plc
Barclays PLC is a global banking and financial services company headquartered in London, United Kingdom. As of 2010 it was the world's 10th-largest banking and financial services group and 21st-largest company according to a composite measure by Forbes magazine...

, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares
IShares
iShares are a family of exchange-traded funds managed by BlackRock. The first iShares were known as WEBS but were since rebranded.Each iShares fund tracks a bond or stock market index...

 MSCI Index Fund Shares. WEBS tracked MSCI country indices, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trust
Unit Investment Trust
A Unit Investment Trust is a US investment company offering a fixed portfolio of securities having a definite life. UITs are assembled by a sponsor and sold through brokers to investors.-Types:...

s, WEBS were set up as a mutual fund, the first of their kind.

In 1998, State Street Global Advisors introduced the "Sector Spiders
SPDR
SPDR can mean:* Standard & Poor's Depositary Receipts, an exchange-traded fund.* "System Peril Distributed Reflex" is the name given to one of the AIs in the alternate reality game The Haunted Apiary ....

", which follow the nine sectors of the S&P 500. Also in 1998, the "Dow Diamonds" were introduced, tracking the famous Dow Jones Industrial Average
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...

. In 1999, the influential "cubes" were launched attempting to replicate the movement of the NASDAQ-100
NASDAQ-100
The NASDAQ-100 is a stock market index of 100 of the largest non-financial companies listed on the NASDAQ. It is a modified capitalization-weighted index. The companies' weights in the index are based on their market capitalizations, with certain rules capping the influence of the largest components...

.

In 2000 Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. The iShares
IShares
iShares are a family of exchange-traded funds managed by BlackRock. The first iShares were known as WEBS but were since rebranded.Each iShares fund tracks a bond or stock market index...

 line was launched in early 2000. Within 5 years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock
BlackRock
BlackRock, Inc. is an American multinational investment management corporation and the world's largest asset manager. BlackRock is headquartered in Manhattan, New York City, New York, United States and is the leading provider of investment, advisory, and risk management solutions...

 in 2009. The Vanguard Group
The Vanguard Group
The Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $1.6 trillion in assets. It offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. Founder...

 entered the market in 2005.

Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of September 2010, there were 916 ETFs in the U.S., with $882 billion in assets, an increase of $189 billion over the previous twelve months.

Investment uses

ETFs generally provide the easy diversification
Diversification
Diversification may refer to:* Diversification involves spreading investments* Diversification is a corporate strategy to increase market penetration...

, low expense ratios, and tax efficiency of index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...

s, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

. 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. Among the advantages of ETFs are the following:
  • 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 do not have 12b-1 fees
    Mutual fund fees and expenses
    Mutual fund fees and expenses are charges that may be incurred by investors who hold mutual funds. Running a mutual fund involves costs, including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses...

    .

  • 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
    Hedge (finance)
    A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

     strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are 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 do not 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 indices, broad-based international and country-specific indices, industry sector-specific indices, bond indices, 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.

Index ETFs

Most ETFs are index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...

s that hold securities and attempt to replicate the performance of a stock market index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....

. 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. Some index ETFs, known as leveraged ETFs or inverse ETFs
Inverse exchange-traded fund
An inverse exchange-traded fund is an exchange-traded fund , traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track...

, use investments in derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

 to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of 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. As of November 2010 an index ETF, namely Standard & Poor's Depositary Receipts
Standard & Poor's Depositary Receipts
The Standard & Poor's Depositary Receipts were launched by Boston asset manager SSgA State Street Global Advisors on January 29, 1993 as the first exchange-traded fund in the United States ; and are part of the SPDRs ETF chain.Designed and developed by American Stock Exchange executives Nathan Most...

 (SPDR S&P 500), was the largest ETF by market capitalization.

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication". Other index ETFs use "representative sampling", investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. For index ETFs that invest in indices with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.

Commodity ETFs or ETCs

Commodity ETFs (ETCs or CETFs) invest in commodities, such as precious metals and futures
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

. Among the first commodity ETFs were gold exchange-traded fund
Gold exchange-traded fund
Gold exchange-traded products are exchange-traded funds , closed-end funds and exchange-traded notes that aim to track the price of gold. Gold exchange-traded products are traded on the major stock exchanges including Zurich, Mumbai, London, Paris and New York. , physically backed funds held...

s, which have been offered in a number of countries. The idea of a Gold ETF was first officially conceptualised by Benchmark Asset Management Company Private Ltd
Benchmark Asset Management Company Private Ltd
-Introduction:Benchmark Asset Management Company Pvt Ltd. is a SEBI registered Asset Management Company launched in June 2001. BAMC is an asset management company in India with primary focus on indexing...

 in India when they filed a proposal with the SEBI in May 2002. The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund
Silver exchange-traded fund
Silver exchange-traded products are exchange-traded funds , exchange-traded notes and closed-end funds that aim to track the price of silver. Silver exchange-traded products are traded on the major stock exchanges including the London and New York Stock Exchanges...

 was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares
SPDR Gold Shares
SPDR Gold Shares is part of the SPDR family of exchange-traded funds managed and marketed by State Street Global Advisors...

, was the second-largest ETF by market capitalization.

However, generally commodity ETFs are index funds tracking non-security indices
Index (economics)
In economics and finance, an index is a statistical measure of changes in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, and employment. Economic indices track economic health from...

. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940
Investment Company Act of 1940
The Investment Company Act of 1940 is an act of Congress. It was passed as a United States Public Law on August 22, 1940, and is codified at through . Along with the Securities Exchange Act of 1934 and Investment Advisers Act of 1940, and extensive rules issued by the Securities and Exchange...

 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter
No-action letter
A no-action letter is a letter written by the staff members of a government agency, requested by an entity subject to regulation by that agency, indicating that the staff will not recommend that the agency take legal action against the entity should the entity engage in a course of action proposed...

 under the Securities Exchange Act of 1934
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...

. They may, however, be subject to regulation by the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....

.

Exchange-traded commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to ETFs and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on-Exchange, during market hours.

The earliest commodity ETFs (e.g., GLD
SPDR Gold Shares
SPDR Gold Shares is part of the SPDR family of exchange-traded funds managed and marketed by State Street Global Advisors...

 and SLV) actually owned the physical commodity (e.g., gold and silver bars). Similar to these are (palladium) and (platinum). However, most ETCs implement a futures trading strategy, which may produce quite different results from owning the commodity.

Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs
Soft commodity
A soft commodity is a commodity such as coffee, cocoa, sugar, corn, wheat, soybean and fruit. This term generally refers to commodities that are grown, rather than mined. Soft commodities play a major part in the futures market...

 and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent. For example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the novice investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.

Bond ETFs

Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issues by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions. There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by fees if bought and sold through a third party.

Currency ETFs or ETCs

In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank
Deutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...

's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

, and later in 2008 the Sterling Money Market ETF and US Dollar Money Market ETF in London. In 2009, ETF Securities
ETF Securities
ETF Securities is a global company based in London, UK, specialising in managing exchange-traded funds , Exchange Traded Commodities and Exchange Traded Currencies - History :...

 launched the world's largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.

Actively managed ETFs

Actively managed ETFs (AMETFs) are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. 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 is willing to consider allowing actively managed ETFs that are not fully transparent in the future.

The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front run
Front running
Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers...

 its trades. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.

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.

Leveraged ETFs

Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more pronounced than the Dow Jones Industrial Average
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...

 or the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...

. A leveraged inverse (bear) ETF
Inverse exchange-traded fund
An inverse exchange-traded fund is an exchange-traded fund , traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track...

 fund on the other hand may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

 and rebalancing to achieve the desired return. The most common way to construct leveraged ETFs is by trading futures contracts.

The rebalancing of leveraged ETFs may have considerable costs when markets are volatile. The problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year(0.9982^252=0.63). Investors may however circumvent this problem by buying or writing futures directly, accepting a varying leverage ratio.

A more reasonable estimate of daily market changes is 0.5%, which leads to a 2.6% yearly loss of principal in a 3x leveraged fund.

Costs

Because ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. For example, a typical flat fee schedule from an online brokerage firm in the United States range from $10 to $20, but can be as low as $0 with discount brokers. Due to this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed immediately, while for someone making a $200,000 investment, the commission cost may be negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Thus when low or no-cost transactions are available, ETFs become very competitive.

ETFs have a lower expense ratio
Expense Ratio
The Total Annual Fund Operating Expenses is the line of the fee table in the prospectus that represents the total of all of a mutual fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets...

 than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. Mutual funds can charge 1% to 3%, or more; index fund expense ratios 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.

The cost difference is more evident when compared with mutual funds that charge a front-end or back-end load as ETFs do not have loads at all. The redemption fee and short-term trading fees are examples of other fees associated with mutual funds that do not exist with ETFs. Traders should be cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.

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
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...

 that is not 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 would 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 most cases, ETFs are more tax-efficient than conventional mutual funds in the same asset
classes or categories. Because Vanguard's ETFs are a share-class of their mutual funds, they don't get all the tax advantages if there are net redemptions on the mutual fund shares. Although they do not get all the tax advantages, they get an additional advantage from tax loss harvesting any capital losses from net redemptions.

In the U.K., ETFs can be shielded from capital gains tax
Capital gains tax
A capital gains tax is a tax charged on capital gains, the profit realized on the sale of a non-inventory asset that was purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property...

 by placing them in an Individual Savings Account
Individual Savings Account
An Individual Savings Account is a financial product available to residents in the United Kingdom. It is designed for the purpose of investment and savings with a favourable tax status. Money is contributed from after tax income and not subjected to income tax or capital gains tax within a holding...

 or self-invested personal pension
Self-invested personal pension
A Self-Invested Personal Pension is the name given to the type of UK-government-approved personal pension scheme, which allows individuals to make their own investment decisions from the full range of investments approved by HM Revenue & Customs ....

, in the same manner as many other shares. Because UK-resident ETFs would be liable for UK corporation tax on non-UK dividends, most ETFs which hold non-UK companies sold to UK investors are issued in Ireland or Luxembourg.

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
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...

, 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
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

 (puts
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...

 and calls
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...

) to be written against them. Covered call
Covered call
A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If a trader buys the underlying instrument at the same time as he sells the call, the strategy is often...

 strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on calls written against them. Mutual funds do not offer those features.

Criticism

John C. Bogle, founder of the Vanguard Group
The Vanguard Group
The Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $1.6 trillion in assets. It offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. Founder...

, a leading issuer of index mutual 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 is 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 indices is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indices. The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.

According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed in 2009 their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008. Part of this so-called tracking error
Tracking error
In finance, tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. The most common measure is the root-mean-square of the difference between the portfolio and index returns....

 is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent, such as emerging-market stocks, future-contracts based commodity indices and junk bonds.

The tax advantages of ETFs are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place). However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.

In a survey of investment professionals, the most frequently cited disadvantage of ETFs was the unknown, untested indices used by many ETFs, followed by the overwhelming number of choices.

Some critics claim that ETFs can be, and have been, used to manipulate market prices, including having been used for short selling
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...

 that has been asserted by some observers (including Jim Cramer of theStreet.com) to have contributed to the market collapse of 2008.

Issuers of ETFs

  • Bips Investment Managers issues Bips (Beta Investment Performance Securities).
  • BNP Paribas
    BNP Paribas
    BNP Paribas S.A. is a global banking group, headquartered in Paris, with its second global headquarters in London. In October 2010 BNP Paribas was ranked by Bloomberg and Forbes as the largest bank and largest company in the world by assets with over $3.1 trillion. It was formed through the merger...

     issues EasyETFs.
  • BlackRock
    BlackRock
    BlackRock, Inc. is an American multinational investment management corporation and the world's largest asset manager. BlackRock is headquartered in Manhattan, New York City, New York, United States and is the leading provider of investment, advisory, and risk management solutions...

     issues iShares
    IShares
    iShares are a family of exchange-traded funds managed by BlackRock. The first iShares were known as WEBS but were since rebranded.Each iShares fund tracks a bond or stock market index...

    .
  • Charles Schwab
    Charles Schwab
    Charles Schwab may refer to:*Charles M. Schwab , American steel magnate*Charles R. Schwab , founder of the eponymous brokerage*Charles Schwab Corp., an American based brokerage firm...

     offers several commission-free ETFs for its clients.
  • Deutsche Bank
    Deutsche Bank
    Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...

     issues db x-trackers ETFs, as well as managing PowerShares DB commodity- and currency-based ETFs.
  • ETF Securities
    ETF Securities
    ETF Securities is a global company based in London, UK, specialising in managing exchange-traded funds , Exchange Traded Commodities and Exchange Traded Currencies - History :...

     issues ETFs or specialised commodity ETCs.
  • Global X Funds
    Global X Funds
    Global X Funds is a New York-based provider of exchange-traded funds that facilitates access to investment opportunities across the global markets. As of March 1, 2011, it had over $1.5 billion in managed assets. The ETF provider focuses on global commodities, developed markets and emerging markets...

     issues ETFs.
  • Guggenheim Funds issues specialty Guggenheim Funds ETFs.
  • Invesco issues PowerShares ETFs, as well as BLDRS based on American Depositary Receipt
    American Depositary Receipt
    An American depositary receipt is a negotiable security that represents the underlying securities of a non-U.S. company that trades in the US financial markets...

    s.
  • Lyxor Asset Management issues Lyxor ETFs.
  • Merrill Lynch
    Merrill Lynch
    Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...

     issues HOLDRs.
  • Source UK Services, a European joint-venture between Bank of America Merrill Lynch
    Bank of America
    Bank of America Corporation, an American multinational banking and financial services corporation, is the second largest bank holding company in the United States by assets, and the fourth largest bank in the U.S. by market capitalization. The bank is headquartered in Charlotte, North Carolina...

    , Goldman Sachs
    Goldman Sachs
    The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...

    , Morgan Stanley
    Morgan Stanley
    Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....

    , Nomura
    Nomura Securities Co.
    is a wholly owned subsidiary of Nomura Holdings, Inc. , which forms part of the Nomura Group. It plays a central role in the securities business, the Group's core business. Nomura is a financial services group and global investment bank. Based in Tokyo and with regional headquarters in Hong Kong,...

     and J. P. Morgan
    J. P. Morgan
    John Pierpont Morgan was an American financier, banker and art collector who dominated corporate finance and industrial consolidation during his time. In 1892 Morgan arranged the merger of Edison General Electric and Thomson-Houston Electric Company to form General Electric...

     issues ETFs and ETCs
  • State Street Global Advisors
    State Street Global Advisors
    State Street Global Advisors is the investment management division of State Street Corporation and the world’s second largest asset manager, with $1.9 trillion in assets under management as of June 2010....

     issues SPDR
    SPDR
    SPDR can mean:* Standard & Poor's Depositary Receipts, an exchange-traded fund.* "System Peril Distributed Reflex" is the name given to one of the AIs in the alternate reality game The Haunted Apiary ....

    s.
  • Van Eck Global
    Van Eck Global
    Van Eck Associates Corporation and Van Eck Securities Corporation are together referred to as Van Eck Global.- About Van Eck :Van Eck Global is an investment management firm founded in 1955 and based in New York City. The firm was among the first U.S...

     issues Market Vectors ETFs.
  • Vanguard Group issues Vanguard ETFs, formerly known as VIPER
    Viper
    -Animals:* Viper , any snake in the family Viperidae* Water viper , a venomous snake found in the eastern United States* Eastern Hognose Snake , a harmless snake found in North America* Viperfish...

    s.

See also

  • Collective investment scheme
    Collective investment scheme
    A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...

  • Enhanced indexing
    Enhanced Indexing
    In finance, enhanced indexing is a catch-all term that describes strategies employed to outperform traditional indexing. Enhanced indexing attempts to generate modest excess returns compared to index funds and other passive management techniques.-Features:...

  • Exchange-traded note
  • Investment trust
    Investment trust
    An Investment trust is a form of collective investment found mostly in the United Kingdom. Investment trusts are closed-end funds and are constituted as public limited companies....

  • Pension fund
    Pension fund
    A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...

  • Separately managed account
    Separately managed account
    A separately managed account is an individual managed investment account offered typically by a brokerage firm through one of their brokers or financial consultants and managed by independent investment management firms and have varying fee structures...


Further reading

  • Carrell, Lawrence. ETFs for the Long Run: What They Are, How They Work, and Simple Strategies for Successful Long-Term Investing. JW Wiley, 2008. ISBN 978-0-470-13894-6
  • Ferri, Richard A. The ETF Book: All You Need to Know About Exchange-Traded Funds. Wiley, 2009. ISBN 0470537469
  • Humphries, William. Leveraged ETFs: The Trojan Horse Has Passed the Margin-Rule Gates. 34 Seattle U.L. Rev. 299 (2010), available at http://lawpublications.seattleu.edu/sulr/vol34/iss1/8/.
  • Koesterich, Russ. The ETF Strategist: Balancing Risk and Reward for Superior Returns. Portfolio, 2008. ISBN 978-1-59184-207-1

External links

The source of this article is wikipedia, the free encyclopedia.  The text of this article is licensed under the GFDL.
 
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