Exchange-traded fund

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Exchange-traded funds (or ETFs) are collective investment schemes, traded as shares on most global stock exchanges. Typically, ETFs try to replicate a stock market index such as the S&P 500 (SPY) or 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:

  • An exchange listing and ability to trade continually;
  • They are index-linked rather than actively managed;
  • Through dynamic and quantitative strategies, these can be dynamic rather than static indexing strategies
  • The ability to handle contributions and redemptions on an in-kind basis (typically in large blocks of shares only); and
  • Their 'value' (but not necessarily the price at which they trade—they can trade at a 'premium' or 'discount' to the 'underlying' assets' value) derives from the value of the 'underlying' assets comprising the fund.

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.

Contents

[edit] Index basis

Many current U.S. ETFs are based on some index; for example, SPDRs (Standard & Poor's Depository Receipts, or "Spiders") 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 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.

[edit] Creation and redemption of shares

Rather than the fund manager dealing directly with shareholders, institutional investors will create a portfolio of shares identical to the ETF and loan them to the fund manager. The portfolio is then incorporated in the ETF and ETF shares are created. Typically a creation unit consists of 50,000 shares.

ETF shares are sold and resold freely among large investors on the open market. If they purchase a sufficient amount of shares, the investor can exchange one full creation unit of ETF shares for the underlying shares of stock. The ETF creation unit is then destroyed and the underlying stocks are delivered out of the trust.

The attraction of this method of dealing for the ETF fund manager is that the institutional investors cover the dealing costs in purchasing the required shares to make up the portfolio. The reason they are willing to do this is the profit they can make 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.

[edit] Actively managed ETF

People have talked about 'actively managed ETF' for a long time[citation needed], based somewhat on analogy with mutual funds. Others feel that such a thing is contradictory and nonsensical. Some have sought to bring the much older (and normally actively managed) Investment Trust class of fund under the ETF umbrella, pointing out the fact that these are also funds that trade on exchanges.

ETFs are mainly exchanged 'in-kind'; holdings of ETFs are made available daily. This is felt to be a strength since no one knows more than anyone else about what the fund holds. If holdings were secret, it would be difficult to buy an ETF, since one would not know what shares to transfer; similarly, if one sells and gets the component shares, the holdings would not be secret. This seems to cause problems for an actively managed fund. Similarly, arbitrageurs are less likely to bid aggressively if they don't know what they are buying and selling. All of this is in contrast to mutual funds, which are allowed to keep holdings unknown for many months. Lastly, some people think that owners of ETFs are more sophisticated, therefore more likely to be proponents of indexing (a passive strategy). So it is not immediately obvious who would buy actively managed ETFs.

[edit] Usage

Today ETFs present a viable alternative investment option to traditional open-ended mutual funds, especially open-ended index funds. There are many available ETFs that attempt to track all kind of indexes (such as large-cap, mid-cap, small-cap, etc), specialties (such as value and growth), industries, countries, precious metals and other commodities or commodity indices like GSCI; and more are being developed for the future.

[edit] History

The first ETF was introduced on the Toronto Stock Exchange in 1990.[citation needed]

There are over one hundred ETFs traded on the American Stock Exchange, with more in other countries. ETFs have been gaining popularity ever since they were introduced on the American Stock Exchange in the mid 1990s, beginning with SPDR in 1993. ETFs are attractive to investors because they offer the diversification of mutual funds with the features of a stock. The popularity 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 Barclays and State Street typically have the most money under management of all companies. This can raise corporate governance issues as often the largest owner of a listed company is a money management company - which simply owns that company as part of a portfolio of companies, designed to outperform other portfolios - and thus has little view or scrutiny of individual companies' internal issues.

[edit] ETFs vs. open-ended funds

An advantage of mutual funds is that they have lower costs if you only invest a little bit of money, or invest small monthly or quarterly amounts. Since ETFs are traded on the stock market, every trade has commission costs. Many mutual funds do not have such costs. If an investor likes to invest, say, $100 or $500 every month, mutual funds are likely to cost less. However, some online brokers do not charge commissions on ETF transactions, and consequently, the above sentences may no longer be valid [2].

There are many advantages to ETFs, and these advantages will likely increase over time. Most ETFs have a lower expense ratio than comparable mutual funds. 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.

ETFs are more tax-efficient than mutual funds in some jurisdictions [3]. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to their shareholders by the end of the quarter. This can happen when stocks are added to and removed from the index, or when a large number of shares are redeemed (such as during a panic). 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 on the stock market, as they would a stock), so that investors generally only realize capital gains when they sell their own shares.

Perhaps the most important, although subtle, 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 do not offer those features.

For example, an investor in an open-ended 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 open-ended funds – if your broker even allows them. An ETF is continually priced throughout the day and therefore is not 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 SPY, DIA, and QQQQ can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.

A more subtle advantage is that ETFs, like closed-ended funds, are immune from some market timing problems that have plagued open-ended mutual funds. In these timing attacks, large investors trade in and out of an open ended fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term unit holders. With an ETF (or closed-ended fund) such an operation is not possible--the underlying assets of the fund are not affected by its trading on the market.

[edit] ETF Offerings Map

Needs URLs, nations, and sectors expanded

Development/Region/Country Total Market Large Cap, Value Large Cap, Blend Large Cap, Growth Mid Cap, Value Mid Cap, Blend Mid Cap, Growth Small Cap, Value Small Cap, Blend Small Cap, Growth Micro Cap, Value Micro Cap, Blend Micro Cap, Growth Sector - Natural Resources Sector - Real Estate Sector - Precious Metals
DEVELOPMENT
-Developed (WW ex-Emerging) *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***
-Emerging *** *** ADRE EEM VWO *** *** *** *** *** *** *** *** *** *** *** *** ***
REGION
-Worldwide *** DGT IOO *** *** *** *** *** *** *** *** *** *** *** XLE IYE IXC PRFE DKA IGE VDE IEZ OIH PXE XME VAW IEO XOP PXJ XES PBW *** IAU SLV GDX GLD PRFM
-International (WW ex U.S.) *** ADRD DWM DTH DOL DOO EFV PID EFA DIM EFG DLS *** *** *** *** *** *** *** *** *** *** ***
-North America *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***
-Latin America *** *** ILF *** *** *** *** *** *** *** *** *** *** *** *** ***
-South America *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***
-Europe *** ADRU FEZ FEU DEW DEB EKH IEV VGK *** *** *** *** DFE *** *** *** *** *** *** *** ***
-Pacific in-Japan *** ADRA *** *** *** *** *** *** *** *** *** *** *** *** *** ***
-Pacific ex-Japan *** DNH DND EPP *** *** *** *** *** *** *** *** *** *** *** *** ***
-Africa *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***
NATION (descending by GDP)
-U.S. DIA FDL DVY IYM JKF NY IWD IWW IVE XLB PFM PWV RPV SDY ELV VTV PRF DTN DHS DLN DTD XLP XLI IYK IYJ IYY KLD JKD NYC IWB IWV OEF ISI IVV MKH PRFS RFN PHJ XLG RSP SPY ELR TMW VDC VIG VIS VV VTI XLY QQEW RTH HHH IYC JKE IWF IWZ IVW QQQQ PPA PWB RPG ELG VCR VUG QQEW ONEQ FPX PIV DON JKI IWS IJJ PWP PEY RFV EMV IYT JKG IWR IJH MDY PEZ PRN EMM VXF VO PWC JKH IWP IJK PWJ PWO RFG EMG DES JKL IWN IJS PWY RZV DSV VBR JKJ IWM IJR PRFZ PZJ DSC VB JKK IWO IJT PWT RZG DSG VBK *** FDM IWC PZI *** *** ICF IYR RWR VNQ ITB XHB PKB ***
-Japan *** DXJ DNL EWJ ITF *** DFJ *** *** *** *** *** *** *** *** *** *** ***
-UK *** EWU *** *** *** *** *** *** *** *** *** *** *** *** *** ***
-Germany *** EWG *** *** *** *** *** *** *** *** *** *** *** *** *** ***
-China *** *** FXI PGJ *** *** *** *** *** *** *** *** *** *** *** *** ***
-Hong Kong *** *** EWH *** *** *** *** *** *** *** *** *** *** *** *** ***
-Canada *** *** EWC *** *** *** *** *** *** *** *** *** *** *** *** ***
etc. *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***

[edit] Major Issuers of ETFs

[edit] Major Users of ETFs

[edit] Top U.S. ETFs

The first, and most widely held (as of November 2004) US ETF is the Standard & Poor's Depositary Receipt, abbreviated SPDR. Shares of SPDR, called "spiders", are traded on the American Stock Exchange under the ticker SPY. Also popular and well known are the ETFs that track the NASDAQ-100 index ("qubes") and the Dow Jones Industrial Average ("diamonds").

Top 10 US-based ETFs, by assets under management:

(as of December 2005)

[edit] European ETFs

In the European Union many ETFs are traded as cross border UCITS III funds. For example the UK iShares are Irish registered UCITS funds and trade on the London Stock Exchange. The European ETF market leader is Indexchange Investments AG, whose funds are listed in Germany on the Deutsche Börse. Indexchange was a subsidiary of HypoVereinsbank. It has been acquired by Barclays Global Investors [1]

[edit] Swedish ETFs

In Sweden six ETFs exist as of November 2006, all provided by XACT Fonder:

  • XACT Bull - leveraged ETF tracking 1,5 times daily OMXS30 returns
  • XACT Bear - like Bull, but inverse, Bear gains from market declines
  • XACT OMXS30 - tracking 30 most traded stocks in Stockholm Stock Exchange
  • XACT OMXSB - tracking 80-100 most traded stocks in Stockholm Stock Exchange
  • XACT F Euro - Fundamentally Weighted index, about 270 stocks in Eurozone
  • XACT VINX30 - tracking 30 most traded stocks in the Nordic region (Sweden, Norway, Finland, Denmark)

[edit] Finnish ETFs

  • SGL OMHXH25 - It is a market value weighted index that consists of the 25 most-traded stock classes. Provided by Seligson & Co Fund Management

[edit] Canadian ETFs

In Canada, Barclays Global Investors is the main ETF provider, offering ETFs under the iShares brand name:

  • XIC-- tracks the S&P/TSX Composite Total Return Index
  • XIU -- tracks the S&P/TSX 60 Total Return Index
  • XMD -- tracks the S&P/TSX MidCap Index
  • XEG -- tracks the S&P/TSX Capped Energy Index
  • XIT -- tracks the S&P/TSX Capped Information Technology Index
  • XGD -- tracks the S&P/TSX Capped Gold Index
  • XFN -- tracks the S&P/TSX Capped Financials Index
  • XMA -- tracks the S&P/TSX Capped Materials Index
  • XRE -- tracks the S&P/TSX Capped Real Estate Investment Trust Index
  • XTR -- tracks the S&P/TSX Income Trust Index
  • XDV -- tracks the Dow Jones Canada Select Dividend Index
  • XSB -- tracks the Scotia Short-term bond index
  • XBB -- tracks the Scotia Capital Bond Index
  • XRB -- tracks the Scotia Capital Real Return Bond Index™
  • XSP -- currency hedged exposure to the USA S&P 500 index
  • XIN -- currency hedged exposure to MSCI EAFE indices

Claymore Investments also offers a series of ETFs available in Canada:

  • CBQ Claymore BRIC ETF -- tracks the BNY BRIC Select ADR Index (Brazil, Russia India and China)
  • CDZ Claymore CDN Dividend & Income Achievers ETF -- tracks Mergent’s Canadian Dividend & Income Achievers Index.
  • CLO Claymore Oil Sands Sector ETF -- tracks the Sustainable Oil Sands Sector Index
  • CLU Claymore US Fundamental ETF (Canadian Dollar Hedged) -- tracks the FTSE RAFI US 1000 Canadian Dollar Hedged Index
  • CRQ Claymore Canadian Fundamental Index ETF -- tracks the FTSE RAFI Canada Index

Horizons Betapro also offers a series of ETFs available in Canada:

  • HXU the "HBP 60 Bull + ETF" -- tracks two times (200%) the daily performance of the S&P/TSX 60 Total Return Index
  • HXD the "HBP 60 Bear + ETF" -- tracks two times (200%) the inverse (opposite) of the daily performance of the S&P/TSX 60 Total Return Index

[edit] Hong Kong ETFs

[edit] Top Republic of Korea ETFs

All ROK-based ETFs, as of June 2006:

  • KODEX 200
  • KOSEF
  • KODEX Baedang ('Baedang' means 'dividend' in Korean)
  • KODEX KRX 100
  • KODEX Star
  • Lyxor ETF MSCI Korea

[edit] Commodity ETFs

Commodity ETFs, also known as exchange-traded commodities (ETCs), track a specific commodity or a general commodity index, such as:

Since September 2006, numerous ETFs have been available on the London Stock Exchange [5]. ETCs invest in real commodities (via future contracts or storing gold bars, for example) and not in commodity producing companies, such as mining companies, though of course, mining-company ETFs also exist.

[edit] See also

[edit] References

  1. ^ [1]

[edit] External links


Investment management

Collective investment schemes:  Common contractual funds • Fonds commun de placements • Investment trusts • Hedge funds • Unit trusts • Mutual funds • ICVC • SICAV • Unit Investment Trusts • Exchange-traded funds • Offshore fund • Unitised insurance fund

Styles and theory:  Active management • Passive management • Index fund • Efficient market hypothesis • Socially responsible investing • Net asset value

Related Topics: List of asset management firms • Umbrella fund • Fund of funds • UCITS


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