Exchange-traded fund

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Exchange-traded funds (or ETFs) are open-ended collective investment schemes, traded as shares on most global stock exchanges.

The legal structure and makeup varies around the world, however the major common features include:

  • An exchange listing and ability to trade continually
  • Typically they are index-linked rather than actively managed, although this is becoming increasingly less of a characteristic
  • The ability to handle contribution and redemptions on an in-kind basis (typically in large blocks of shares only)
  • 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 to traditional open-ended collective investments. The ETF’s structure allows for a diversified, low cost, low turnover index investment. This appeals to both institutional and retail investors to use as a long term hold and for selling short and hedging strategies.

Typically, ETFs try to replicate a stock market index such as the S&P 500 or Hang Seng Index, a market sector such as energy or technology, or a commodity such as gold or petroleum.

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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.

It is unknown whether the SEC may in future approve an ETF that is not based on some index. In their web site, they state flatly that an ETF is "a type of investment company whose investment objective is to achieve the same return as a particular market index".

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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.

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Actively managed ETF?

People have talked about 'actively managed ETF' for a long time, based somewhat on analogy with mutual funds. Others feel that such a thing is contradictory and nonsensical.

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. So it's not obvious who would buy such a thing.

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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, and even commodities (while commodity funds like Gold Shares are technically not ETFs, they trade like ETFs). And more are being developed for the future. There are discussions of ETFs for other indices and commodities, as well as actively managed ETFs.

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History

The first ETF was introduced on the Toronto stock exchange in 1989.

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 by the American Stock Exchange in the mid 1990s, beginning with SPY 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 tends to be more tax-favorable.

ETF managers such as Barclays and State Street typically have the highest money under management of all companies. This can raise corporate governance issues as often the largest owner of a company is a money management company which simply owns that company as part of trying to own all companies based on a belief that this strategy will do better than most others.

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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.

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.

In the US only, ETFs are usually more tax-efficient than mutual funds in some jurisdictions [1]. 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). Mutual funds do not offer those features.

For example, an investor in an open-ended 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 so is not subject to this disadvantage, allowing the user to react to adverse or benefic market condition on an intra day basis.

A more subtle advantage is that ETF's, 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.

See Debate on talk page

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Major Issuers of ETFs

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Top U.S. ETFs

The first, and most widely held (as of November 2004) 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)

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European ETFs

In Europe many ETFs are traded as UCITS III funds. For example the UK iShares are Irish registered UCITS funds.

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Swedish ETFs

In Sweden four ETFs exist as of February 2006:

  • XACT BULL
  • XACT BEAR
  • XACT OMXS30
  • XACT OMXSB
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Canadian ETFs

In Canada, Barclays Global Investors is the main ETF provider, offering ETFs under the iUnits 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 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 indicies
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Top Republic of Korea ETFs

All ROK-based ETFs, as of December 2005:

  • KODEX 200
  • KOSEF
  • KODEX Q
  • KODEX BAEDANG
  • KODEX KRX 100
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Commodity ETFs

Commodity ETFs are also known as exchange-traded commodities, or ETCs

  • ETF Securities issues gold and petroleum ETFs
  • iShares issues gold ETF, with silver ETF expected in 2006
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See also

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References

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External links

fr:Tracker (finance) it:Exchange-traded fund he:תעודת סל

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