by Ken Hawkins

Compared to mutual funds, ETFs are relatively new. The first U.S. ETFs were created by State Street Global Advisors with the launch of the S&P 500 depositary receipts, also know as SPDRs ("spiders"). Although the first ETFs tended to track broad market indexes, more recent ETFs have been developed to track sectors, fixed income, global investments, commodities and currencies. According to Morgan Stanley, by the end of 2007, there were 1,171 ETFs trading worldwide, with assets approaching $800 billion.

ETFs represent shares of ownership of a unit investment trust (UIT), which holds portfolios of stocks, bonds, currencies or commodities. ETFs are often compared the mutual funds:
  • Like a mutual fund, an ETF is an investment structure that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. And, like a mutual fund, it also has a prospectus. An ETF delivers a prospectus to the retail purchaser or provides investors a document known as a product description, which summarizes key information about the ETF.

  • A mutual fund investor purchases or redeems directly from the fund, at the mutual fund's net asset value (NAV), which is calculated at the end of each trading day. An investor who buys an ETF purchases the shares on a stock exchange in a process identical to the purchase or sale of any other listed stock. Although most mutual funds are actively managed a significant number of index funds are available. Although most ETFs are passively managed - designed to track specific indexes - a few actively managed ETFs have been introduced.

  • The creation and redemption process for ETF shares is almost the exact opposite to that of mutual fund shares. When investing in mutual funds, investors send cash to the fund company, which then uses that cash to purchase securities and issue additional shares of the fund. When investors want to redeem their mutual fund shares, the shares are returned to the mutual fund company in exchange for cash. The creation of an ETF, however, does not involve cash. (For insight, see An Inside Look At ETF Construction.)
ETFs are security certificates that state the legal right of ownership over a portion of a basket of individual stock certificates. Creating an ETF in the U.S. first requires a fund manager to submit a detailed plan to the Securities and Exchange Commission (SEC). The plan describes a set of procedures and the composition of the ETF.

Typically, only the largest money management firms, with experience in indexing, can create and manage ETFs. These firms are in touch with major investors, pension funds and money managers throughout the world, which have the pool of stocks required for ETF creation. The firms also create demand by lining up customers, either institutional or retail, to buy a newly introduced ETF.

The creation of an ETF officially begins with an authorized participant, also referred to as a market maker or specialist. These are middlemen who assemble the appropriate basket of stocks, typically enough to purchase 10,000 to 50,000 shares of the ETF. The basket of shares is sent to a designated custodial bank, which in turn forwards the ETF shares to the market maker for safekeeping. The minimum basket size is called a creation unit.

To redeem the shares, an authorized participant buys a large block of ETFs, forwards them to the custodial bank and receives an equivalent basket of individual stocks. These stocks can then be sold on a stock exchange although they are usually returned to the institution that loaned the shares.

In theory, an investor can dispose of an ETF in two ways:
  • Redeem the ETF, by submitting the shares to the ETF fund in exchange for the underlying shares
  • Sell the ETF on the secondary market

In practice, the individual investors will do the latter. Because of the limitations placed on the redemption of the ETFs shares, they can not be called mutual funds.

A important characteristic of an ETF is the opportunity for arbitrage. When the ETF price starts to deviate from the underlying net asset value (NAV) of the component stocks, participants can step in and take profit on the differences. If the ETF shares are trading at a discount to underlying securities (a price lower than the NAV), then arbitrageurs buy ETF shares on the open market. The arbitrageurs will then form creation units, redeem the creation units to the custodial bank, receive the underlying securities, and sell them for a profit. If the ETF shares are trading at a premium to the underlying securities (a price higher than the NAV), arbitrageurs will buy the underlying securities on the open market, redeem them for creation units, and then sell the ETF shares for a profit.

The actions of the arbitrageurs result in ETF prices that are kept very close to the NAV of the underlying securities. (For more insight, read Arbitrage Squeezes Profit From Market Inefficiency.)

Popular Families of ETFs

Standard & Poor's Depositary Receipts (SPDRs) are managed by State Street Global Advisors (SSgA). The most popular SPDR is the SPDR S&P 500 EDF (SPY), but State Street Global Advisors also has a series of ETFs that track the major S&P 500 sectors. They are called Select Sector SPDRs.

The iShares family of ETFs is branded and managed by Barclays Global Investors. According to Morgan Stanley, Barclays is the largest providers of ETFs in the world, providing a diverse offering of ETFs covering broad-based U.S., international, industry sectors, fixed income and commodities.

VIPERS ETFs are issued by Vanguard, better known for its diverse selection of index mutual funds. Vanguard Index Participation Receipts (VIPERs) offer a number of different ETFs, ranging form broad-based to industry sector as well as international and bond ETFs. (To learn more read, What is the difference between iShares, VIPERS and spiders?)

The PowerShares family of exchange traded funds is a relatively new provider of ETFs that offers equity ETFs representing broad market, industry sectors, and international indexes as well as fixed income, currency and commodities. The family, which offers the very popular QQQQ, or Nasdaq 100 ETF, also has a number of quantitatively based ETFs developed by using "dynamic indexing", which constantly searches for the best performing stocks within each index.

Next: Exchange-Traded Funds: Features »

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