Frequently Asked Questions About ETF Basics and Structure

What is an ETF?
How are ETFs different from mutual funds?
What is the history of ETFs?
What kind of investments can investors make through ETFs?
How do ETFs work toward their investment objective?
How are ETF shares created and redeemed?
What determines an ETF’s price?
How are ETFs regulated?
Are there other products similar to ETFs?
Are ETFs guaranteed?
What are the costs of purchasing and owning ETFs?

 What is an ETF?

An exchange-traded fund (ETF) is an investment company that issues shares that trade throughout the business day on stock exchanges at market-determined prices. Investors may buy or sell ETF shares through a broker or in a brokerage account, just as they would trade the shares of any publicly traded company.

The two main types of ETFs are index-based ETFs and actively managed ETFs (For more information, see “What kinds of investments can investors make through ETFs?” below). An ETF represents a portfolio of assets, and the types of assets an ETF holds depend on its investment objective. ETFs can hold securities (e.g., stocks and bonds) and other assets (e.g., cash, swaps, and futures and forwards). A much smaller group of funds are based on commodities and hold either commodity-based derivatives or physical commodities such as gold.

 How are ETFs different from mutual funds?

In contrast to ETFs, mutual fund shares are not listed on stock exchanges. Retail investors buy and sell mutual fund shares through a variety of distribution channels, including directly from a fund company or through a financial adviser or broker-dealer.

Another key difference is that mutual fund shares do not trade throughout the day. Rather, mutual funds are redeemable on a daily basis at a price that reflects the current market value of the fund’s portfolio securities. Also, ETFs must disclose information about their holdings daily, while mutual funds only must do so quarterly.

For more on the differences between ETFs and mutual funds, see “Frequently Asked Questions About How ETFs Compare With Other Investments.”

 What is the history of ETFs?

ETFs are a relatively recent innovation to the investment company concept. The first ETF—a broad-based domestic equity fund tracking the S&P 500 index—was introduced in 1993.

Until 2008, the SEC approved only ETFs that tracked designated indexes. In early 2008, the SEC granted approval to several fund sponsors to offer fully transparent actively managed ETFs that meet certain requirements. Among other requirements, these actively managed ETFs must disclose each business day on their publicly available websites the identities and weightings of all securities and other assets held by the ETF. By September of 2011, the total number of index-based and actively managed ETFs domiciled in the U.S. had grown to 1,099 and total net assets were $951 billion. For more on the U.S. ETF market, see “Frequently Asked Questions About the U.S. ETF Market.”

  What kind of investments can investors make through ETFs?

As with mutual funds, investors in ETFs can access a wide variety of investment strategies and markets. ETFs invest in domestic and international stock, bond, and commodities markets using either an index-based investment strategy or an active management investment strategy.

Index-based ETFs invest in securities selected to match market indexes, including broad indexes that track large parts of the stock or bond markets or narrow indexes covering particular market sectors. Some index-based ETFs also invest in commodity-based derivatives. Other index-based ETFs may try to return a multiple of their respective index, an inverse of the index (e.g., the ETF’s value goes up when the index goes down), or even a multiple inverse of the index.

Actively managed ETFs do not seek to track the return of a particular index. Instead, an actively managed ETF’s investment adviser, like that of an actively managed mutual fund, creates a unique mix of investments to meet a particular investment objective and policy.

Finally, some ETFs hold physical commodities. The share prices of these funds are based on spot prices.

 How do ETFs work toward their investment objective?

An ETF originates with a sponsor, who chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways. A replicate index-based ETF holds every security in the target index and invests 100 percent of its assets proportionately in all the securities in the target index. A sample index-based ETF does not hold every security in the target index; instead, the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF when its target index contains thousands of securities or contains securities that are not readily available, such as certain bond issues.

The sponsor of an actively managed ETF also determines the investment objective of the fund and may trade securities at its discretion, much like an actively managed mutual fund. In theory, an actively managed ETF could trade its portfolio securities regularly. In practice, however, most existing actively managed ETFs trade less frequently for a number of reasons, including minimizing the risk of other market participants front-running their trades (submitting trades in advance of the ETF to take advantage of any predictable changes in security prices).

 How are ETF shares created and redeemed?

ETFs are required to publish information about their portfolio holdings daily. Each business day, the ETF publishes a “creation basket”—a specific list of names and quantities of securities or other assets.

Unlike traditional mutual fund shares, ETF shares are created and redeemed by an entity known as an “authorized participant,” which is typically a large institutional investor, such as a broker dealer. An authorized participant provides the creation basket to the ETF. In return for the creation basket or cash (or both), the ETF issues to the authorized participant a “creation unit,” a large block of ETF shares (generally 25,000 to 200,000 shares). The authorized participant can either keep the ETF shares that make up the creation unit or sell all or part of them on a stock exchange. ETF shares are listed on a number of stock exchanges, where investors can purchase them as they would shares of a publicly traded company.

A creation unit is liquidated when an authorized participant returns the specified number of shares in the creation unit to the ETF. In return, the authorized participant receives the daily “redemption basket,” (a set of specific securities and other assets contained within the ETF’s portfolio), cash, or both. The composition of the redemption basket typically mirrors that of the creation basket.

 What determines an ETF’s price?

The price of an ETF share on a stock exchange is influenced by the forces of supply and demand. While imbalances in supply and demand can cause the price of an ETF share to deviate from its underlying value (i.e., the market value of the underlying instruments, also known as the Intraday Indicative Value, or IIV), substantial deviations tend to be short-lived for many ETFs.

Two primary features of an ETF’s structure promote trading of an ETF’s shares at a price that approximates the ETF’s underlying value: portfolio transparency and the ability for authorized participants to create or redeem ETF shares at net asset value (NAV) at the end of each trading day.

The transparency of an ETF’s holdings enables investors to observe discrepancies between the ETF’s share price and its underlying value during the trading day and to attempt to profit from them. ETFs contract with third parties (typically market data vendors) to calculate an estimate of an ETF’s IIV, using the portfolio information an ETF publishes daily. IIVs are disseminated at regular intervals during the trading day (typically every 15 to 60 seconds). Some market participants for whom a 15- to 60-second latency is too long will use their own computer programs to estimate the underlying value of the ETF on a more real-time basis.

If the ETF is trading at a discount to its underlying value, investors may buy ETF shares or sell the underlying securities. The increased demand for the ETF should raise its share price, while sales of the underlying securities should lower their share prices, narrowing the gap between the ETF and its underlying value. If the ETF is trading at a premium to its underlying value, investors may choose to sell the ETF or buy the underlying securities. These actions should bring the price of the ETF and the market value of its underlying securities closer together.

The ability of authorized participants to create or redeem ETF shares at the end of each trading day also helps an ETF trade at market prices that approximate the underlying market value of the portfolio. When a deviation between an ETF’s market price and its underlying value occurs, authorized participants may engage in trading strategies similar to those described above, but will purchase or sell creation units directly with the ETF. For example, when an ETF is trading at a premium, authorized participants may find it profitable to sell short the ETF during the day while simultaneously buying the underlying securities. At the end of the day, the authorized participant will deliver the creation basket of securities to the ETF in exchange for ETF shares that they use to cover their short sales. When an ETF is trading at a discount, authorized participants may find it profitable to buy the ETF shares and sell short the underlying securities. At the end of the day, authorized participants return ETF shares to the fund in exchange for the ETF’s redemption basket of securities that they use for their short positions. These actions by authorized participants, commonly described as “arbitrage opportunities,” help keep the market-determined price of an ETF’s shares close to its underlying value.

 How are ETFs regulated?

The vast majority of assets in ETFs are in funds registered with and regulated by the SEC under the Investment Company Act of 1940. Other ETFs invest in commodity futures and are regulated by the Commodity Futures Trading Commission (CFTC), or invest solely in physical commodities and are regulated by the SEC under the Securities Act of 1933. In addition, the Depository Trust Clearing Corporation oversees the settlement of ETF trades, ensuring that ETF certificates are assigned correctly in a trade.

 Are there other products similar to ETFs?

ETFs are only one type of structured exchange product, and they should not be confused with other types of exchange-traded products, such as closed-end funds or exchange-traded notes, which differ materially from ETFs with respect to their key features and risks. For more, see “Frequently Asked Questions About How ETFs Compare With Other Investments.”

 Are ETFs guaranteed?

While shares of an ETF are regulated under various securities laws, they are not guaranteed against risk of loss. The value of an ETF’s shares may decline. Investors should consider the risks associated with an ETF’s underlying securities, and the liquidity of the ETF itself, before investing. For more on investors and ETFs, see “Frequently Asked Questions About ETFs and Retail Investors.”

 What are the costs of purchasing and owning ETFs?

There are three primary costs to purchasing and owning an ETF.

• Brokerage commissions: Because ETFs are exchange-traded, investors will buy and sell ETFs through a broker who will need to be compensated for this service. Some brokers will charge a flat fee for each buy or sell transaction, while other brokers who may not charge by the trade will usually assess a fee based on the total assets in the investor’s account.
• Bid-ask spreads: An investor will incur a bid-ask spread each time the investor buys or sells an ETF. The bid-ask spread is the difference between the bid price and the ask price of a security. The bid price is the highest price a liquidity provider is willing to pay to buy a security from an investor. The ask price is the lowest price a liquidity provider will accept to sell a security to an investor. Bid prices are almost always lower than ask prices.
• Expense ratios: An ETF has a fund expense ratio, which is expressed as a percentage of fund assets and is paid out of fund assets to the sponsor and other service providers for the expenses of the fund.

January 2012