Exchange Traded Fund (ETF)

November 23, 2010Exchange Traded Fundsby EconomyWatch

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ETF is an acronym for exchange traded fund. ETFs are investment vehicles that comprise of a number of securities or a basket of assets. They are traded just like stocks on a stock exchange. Most ETFs track an index such as the S&P 500 or the Dow Jones Industrial Average.

Features such as tax efficiency, low cost and stock-like characteristics make ETFs a highly attractive investment option. Exchange traded funds have been available in the US financial market since 1993 and in the European market since 1999.

 

Features of an ETF

The undivided interest that an ETF offers in a pool of securities makes it similar to the traditional mutual funds. However, unlike a mutual fund, shares in an exchange traded funds:

  • Can be traded, just like the stocks, through a broker on a securities exchange throughout the day.
  • Are not sold or redeemed at their net asset value.

ETF shares are purchased and redeemed directly from the exchange traded fund by financial institutions. This is done only in large blocks, varying from 25,000 to 200,000 shares. These are called 'creation units'. The purchase or redemption of these creation units is generally in kind. Institutional investors contribute or receive a basket of securities of the same type and proportion that is held by the concerned ETF. In some cases, the substitution by cash may be required or permitted for purchase or redemption.

The portfolios of existing ETFs are transparent. This facilitates institutional investors in deciding the portfolio assets they should assemble for purchasing a creation unit.

 

The Trading of an ETF

A share of an ETF can be obtained or redeemed directly from fund managers only by large institutional investors. Such institutional investors are also called authorized participants. They may either hold the ETF shares or act as market makers in the open market. Other individual investors use a retail brokerage for trading ETF shares in the secondary market created by these authorized participants.

 

ETFs: Benefits and Risks

An ETF gives the advantage of diversifying an index fund. It also provides the ability to buy on margin, to sell short and purchase as little as a single share. However, many ETFs use unknown and untested indexes. Also, ETFs depend upon the efficiency of the mechanism of the arbitrage.

Since ETFs can be bought and sold just like stocks, their net asset value (NAV) is not calculated once a day by fund managers, but on a continuous basis throughout the day by investors. Thus, unlike mutual funds, ETFs are open to price fluctuations during the entire trading period. Since ETFs are traded on the stock market through brokers, minimal interaction with fund houses is required. Fees associated with ETFs are also lower that the mutual fund fees.

Additionally, ETFs afford greater tax efficiency than mutual funds. While these benefits do exist, the one driving the popularity of ETFs is liquidity.

An ETF is an ideal asset allocation tool that significantly limits the investment risks associated with individual stocks. However, ETFs are not without shortcomings. As ETFs are a basket of funds from the same investment category, investors have high exposure to any downturn in that specific category. Moreover, too much flexibility to move in and out of an ETF could tempt investors to jump often between sectors, resulting in missed opportunities, wrong decisions and reduced potential returns. Additionally, buying and selling of ETFs involve brokerage commissions, which can erode the low-expense advantage of ETFs, particularly when the sum being invested is limited.

 

A History of Exchange Traded Funds

The bear market in the US in the first couple of years of the twenty-first century propelled investors towards Exchange Traded Funds, thanks to their combination of stability (similar to mutual funds) and ease of trading as stocks.

ETFs have been traded in the US since 1993 and in Europe since 1999. They owe their origin to a product called Index Participation Shares that was traded on the American Stock Exchange and the Philadelphia Stock Exchange in 1989 as an S&P 500 proxy. This product had to be terminated on account of a lawsuit, but was soon followed by a similar product, namely the Toronto Index Participation Shares, trading on the Toronto Stock Exchange. This product, which tracked the TSE 35 and later the TSE 100 stocks, became highly popular. In the US, Standard & Poor's Depositary Receipts (SPDRs), or "Spiders," were the first ETF to hit the market. Since then, ETFs have flourished and form a significant portion of trading activity on US bourses. As of May 2008, there were 680 ETFs in the US, with $610 billion in assets, according to wikipedia.org.