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  1. Exchange-Traded Funds: Introduction
  2. Exchange-Traded Funds: Background
  3. Exchange-Traded Funds: Features
  4. Exchange-Traded Funds: Biggest ETFs and ETF Providers
  5. Exchange-Traded Funds: Active Vs. Passive Investing
  6. Exchange-Traded Funds: Index Funds Vs. ETFs
  7. Exchange-Traded Funds: Equity ETFs
  8. Exchange-Traded Funds: Fixed-Income and Asset-Allocation ETFs
  9. Exchange-Traded Funds: ETF Alternative Investments
  10. Exchange-Traded Funds: ETF Investment Strategies
  11. Exchange-Traded Funds: Best Practices for Trading ETFs
  12. Exchange-Traded Funds: Conclusion

An ETF is a pooled investment vehicle – similar to a mutual fund – that offers investors a proportionate share in a pool of stocks, bonds, commodities, and/or other assets. The key distinguishing feature of an ETF is that it trades throughout the day on an exchange (hence the term “exchange-traded”) at a market-determined price, just like a stock. In contrast, mutual funds are traded at a single price based on the Net Asset Value (NAV) that is calculated at the end of the trading day. Another key distinction between ETFs and mutual funds is that ETFs are bought and sold by investors and their financial advisors through a brokerage firm; mutual fund trades are transacted directly with the fund company, although the orders are usually placed through a brokerage firm. (Related video: An Introduction To Exchange-Traded Funds (ETFs)

ETF Formation

The first step in the formation of a new ETF occurs when an ETF sponsor – the company or financial institution that creates and administers the ETF – chooses its investment objective. For an index-based ETF, the sponsor also has to choose the index and the method of tracking it.

While most early ETFs tracked traditional market cap-weighted indexes, newer ETFs follow benchmarks that use various index-construction methodologies such as equal-weighted index components, or based on fundamental factors like low valuations or below-average volatility. The soaring popularity of such ETFs has generated a distinct class of ETFs known as “Smart Beta” ETFs, which follow rules-based strategies that use alternative methodologies to market cap-weighted indexes.

Further along the spectrum from passive ETFs and Smart Beta ETFs are actively managed ETFs. Similar to an actively managed mutual fund, the determination of the investment objective – such as investing in a certain asset class, or outperforming the broad market or a specific sector, for example – by the sponsor is a key part of the ETF formation process.

An index-based ETF will generally replicate its index by investing all of its assets in the securities that constitute the target index, in the same proportion or weights as the index. An ETF that is virtually identical to the index it tracks should have minimal tracking error, which is a measure of how closely the ETF tracks its index. However, it is often not practical to include all the index securities in the ETF for various reasons – such as if the number of securities are too numerous as is the case with some total market stock indices, or if there are restrictions on ownership as sometimes occurs with foreign securities. In these cases, the ETF may invest in a representative sample of index securities.  

Once the details of the ETF are finalized, the ETF sponsor submits a detailed plan to the SEC, describing the ETF’s composition, processes and procedures etc. Upon approval of the plan, the sponsor enters into a legal agreement with an Authorized Participant (AP) – who is typically a market maker or large institutional investor with an ETF trading desk – to create and redeem shares of the ETF. Note that in some cases, the sponsor and AP may be the same entity.

Creation and Redemption of ETF shares

The vast majority of ETFs have a structure similar to mutual funds, i.e. they are structured as registered open-end management investment companies. A handful of early ETFs were structured as registered Unit Investment Trusts (UITs) under the Investment Company Act. However, UITs have a number of restrictions, including the requirement to have fixed portfolios, replicating indexes rather than sampling, and being unable to participate in activities that require an investment adviser such as security selection and securities lending. As a result, the UIT structure is not popular with newer ETFs, which generally have the open-end structure because of its increased flexibility in portfolio management, dividend investment and portfolio securities lending.

The number of shares outstanding in an ETF can expand or contract based on demand, thanks to the creation / redemption mechanism in the open-end ETF structure. This differs from a stock, where the number of shares outstanding is generally fixed (unless there is a secondary issue that increases shares outstanding).

ETF shares are created when an Authorized Participant – whose function is to acquire the securities that make up the ETF – submits an order for one or more ETF “creation units.” A creation unit is a specified block of ETF shares, typically 50,000, that can be bought or sold from the ETF sponsor at NAV. The AP assembles the appropriate portfolio of stocks that comprises the ETF, and delivers this portfolio of stocks to the ETF sponsor’s designated custodial bank. In exchange, the custodial bank forwards the ETF creation units to the AP.

For example, if an ETF tracks the S&P 500, the AP buy shares in all the S&P 500 constituents in exactly the same proportions as their weights in the index. It then delivers this portfolio of stocks to the ETF sponsor (or in reality, its custodian bank), and in return, receives creation units of ETF shares priced at their NAV. Note that the value of the S&P 500 constituent shares delivered by the AP, and the ETF shares it receives from the ETF sponsor, are exactly equal.

The AP will either sell the ETF shares it has received to its clients or other investors, or retain the ETF shares in its inventory fort resale at a later time.

The process works in the reverse manner during redemption. The AP acquires the specified number of ETF shares that form a creation unit, and delivers this creation unit or units to the ETF sponsor. In exchange, the AP receives from the fund sponsor a portfolio of the underlying securities of the ETF. The total value of this portfolio is exactly equal to the value of the creation unit based on the ETF’s NAV at the end of the trading day on which the redemption transaction was initiated.

As these creation and redemption transactions are only “in-kind,” the ETF incurs minimal transaction costs and does not realize capital gains.

The redemption process is generally only available to institutional investors because of the large number of ETF shares that typically make up a creation unit. The retail investor can achieve the same objective by selling the ETF shares on the secondary market.

ETF Liquidity

Unlike individual stocks, whose liquidity is directly related to their traded volume on stock exchanges, ETFs get most of their liquidity from sources other than their trading activity on exchanges. As a result, an ETF’s average daily volume (ADV) is not an accurate gauge of its liquidity. In fact, many ETFs can be traded in amounts that greatly exceed their ADV without having a major impact on their prices.

The main determinant of an ETF’s liquidity is the liquidity of its underlying securities. An ETF that consists of highly liquid securities with substantial traded volume will have a high degree of liquidity as well. An ETF whose underlying securities are illiquid or have scant traded volume will also be similarly illiquid. Thus, an ETF that tracks widely-followed indices like the S&P 500 or Nasdaq-100 will be far more liquid than an ETF that comprises fixed-income securities of a small emerging nation.

There are three levels of liquidity for an ETF. The first level of liquidity on an exchange emanates from the buying and selling transactions of individual investors on the secondary market. The second level of liquidity comes from market makers, who are responsible for posting ETF bid and ask prices on the exchange. The third and arguably the most important source of liquidity comes from the primary market, where the AP and institutional investors can create or redeem ETF shares based on investor demand.

An ETF’s liquidity can be gauged from its bid-ask spread, rather than its ADV. A tight bid-ask spread will indicate that the ETF has good liquidity, even if it has low traded volumes.  

ETF Costs

Like mutual funds, ETFs incur expenses in their day-to-day operations that are passed on to investors. Investors also incur certain other costs when trading ETFs. These include:

  • Operating expenses – The fees that an ETF charges to cover its expenses and for managing the fund are expressed as a percentage of fund assets, known as the management expense ratio (MER). Trading expenses and commissions paid by the ETF, as well as withholding taxes on foreign income, are summarized in a separate category called the trading expense ratio (TER).
  • Broker commissions: Investors who buy and sell ETFs usually do so through a broker, who may charge a flat transaction fee as commission.
  • Bid-ask spread: Investors also have to contend with the bid-ask spread for ETF shares. As noted earlier, the bid-ask spread will be tight for ETFs that are heavily traded or whose underlying securities have ample liquidity.

Regulatory Framework

In the United States, most ETF assets are in funds registered with and regulated by the Securities Exchange Commission (SEC) under the Investment Company Act of 1940. The small proportion of ETFs that invest in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC), although ETFs that invest only in physical commodities are regulated by the SEC under the Securities Act of 1933. In Canada, ETFs are regulated by the securities commissions within each province or territory. 

Exchange-Traded Funds: Features
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