Frequently Asked Questions About Exchange-Traded Funds (ETFs)
What is an ETF?
What kind of investments can investors make through ETFs?
How are ETFs similar to mutual funds?
How are ETFs different from mutual funds?
What is the history of ETFs?
How are ETFs regulated?
How do ETFs work toward their investment objective?
How are ETFs created?
How can an investor be sure that an ETF’s price reflects its asset value?
How many ETFs are available to investors?
Has demand for ETFs grown?
How many Americans own ETFs?
How big are ETF assets relative to all assets managed by mutual funds and other investment companies?
Do ETFs track international indexes?
How popular are sector and commodity ETFs?
What is included in ICI’s monthly ETF report?
An exchange-traded fund (ETF) is an investment company with shares that trade intraday 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 the shares of any publicly traded company.
Unlike traditional mutual fund shares, ETF shares are created by an institutional investor providing a specified basket of securities, cash, or both—often called a “creation basket”—to the ETF. In return, the institutional investor receives a fixed amount of ETF shares, called a “creation unit.” Some or all of these shares may then be sold on a stock exchange. An institutional investor may redeem ETF shares in creation unit increments in exchange for a “redemption basket” of securities, cash, or both.
Retail investors can only buy and sell the ETF shares on an exchange, much as they can buy or sell any listed equity security. Unlike an institutional investor, a retail investor cannot purchase or redeem shares directly from the ETF, as with a traditional mutual fund.
As with mutual funds, investors in ETFs can access a wide variety of investment strategies and markets, both domestic and international. Among other things, ETFs invest in broad and narrow market indexes covering particular market sectors and industries. ETFs also invest in commodities.
Index-based ETFs are designed to track the performance of specified market indexes. In some cases, an ETF may track a multiple of its index, an inverse of its index, or even a multiple inverse of its 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.
An ETF is similar to a mutual fund in that it offers investors a proportionate share in a pool of stocks, bonds, and other assets. It is most commonly structured as an open-end investment company, as are mutual funds, and is governed by the same regulations. Also, like a mutual fund, an ETF is required to post the marked-to-market net asset value of its portfolio at the end of each trading day.
One major difference is that retail investors buy and sell ETF shares on a stock exchange through a broker-dealer, much as they would trade any other type of stock. In contrast, 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.
Mutual funds and ETFs are also priced differently. Mutual funds are “forward priced.” Investors can place orders to buy or sell shares throughout the day, but all orders received during the day will receive the same price—the fund’s net asset value (NAV)—the next time it is computed. Most mutual funds calculate their NAV as of 4:00 p.m. eastern time because that is the time U.S. stock exchanges typically close. In contrast, the price of an ETF share is continuously determined on a stock exchange. Consequently, the price at which investors buy and sell ETF shares may not necessarily equal the NAV of the portfolio of securities in the ETF. In addition, two investors selling the same ETF shares at different times on the same day may receive different prices for their shares, both of which may differ from the ETF’s NAV.
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 after a fund sponsor received U.S. Securities and Exchange Commission (SEC) exemptive relief from various provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. Until 2008, SEC exemptive relief was granted only to ETFs that tracked designated indexes. These ETFs, commonly referred to as index-based ETFs, are designed to track the performance of their specified indexes or, in some cases, a multiple of or an inverse (or multiple inverse) of their indexes.
In early 2008, the SEC granted exemptive relief 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 the component securities and other assets held by the ETF. Actively managed ETFs do not seek to track the return of a particular index. Instead, the investment adviser of an actively managed ETF, like that of an actively managed mutual fund, creates a unique mix of investments to meet a particular investment objective and policy.
By the end of 2008, the total number of index-based and actively managed ETFs had grown to 728, and total net assets were $531 billion. Of these, 12 were actively managed ETFs with less than $250 million in total net assets.
The vast majority of exchange-traded funds are registered with the SEC and, like mutual funds, must comply with the applicable provisions of the Investment Company Act of 1940 and exemptive orders issued under that Act. Different regulations apply to commodity-based ETFs, which hold about 7 percent of ETF assets. Those commodity-based ETFs that invest in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC), while those that invest solely in physical commodities are regulated by the SEC under provisions outside the Investment Company Act of 1940.
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 because it 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.
The sponsor of an actively managed ETF also determines the investment objectives 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 tend to trade only weekly or monthly 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).
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 designed to track the performance of the portfolio as a whole. In the case of an index-based ETF, the creation basket is either a replicate or a sample of the ETF portfolio (which samples the index). Actively managed ETFs and certain types of index-based ETFs are required to publish their complete portfolio holdings in addition to their creation basket.
ETF shares are created when an “authorized participant”—typically an institutional investor—deposits the daily creation basket or cash with the ETF. In return for the creation basket or cash (or both), the ETF issues to the authorized participant a “creation unit” that consists of a specified number of ETF shares. Creation units are large blocks of shares that generally range in size from 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.
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 NAV, substantial deviations—for many ETFs—tend to be short-lived. Two primary features of an ETF’s structure promote trading of an ETF’s shares at a price that approximates the ETF’s NAV: portfolio transparency and the ability for authorized participants to create or redeem ETF shares at NAV at the end of each trading day.
ETFs contract with third parties (typically market data vendors) to calculate a real-time estimate of an ETF’s current value, often called the Intraday Indicative Value (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). Investors can observe any discrepancies between the ETF’s share price and its IIV during the trading day. When a gap exists between the ETF share price and its IIV, investors may decide to trade in either the ETF share or the underlying securities that the ETF holds in its portfolio in order to attempt to capture a profit. This trading can help to narrow that gap either by moving the price of the ETF share closer to its IIV or moving the prices of the underlying securities so that the IIV moves closer to the price of the ETF share.
The ability of authorized participants to create or redeem ETF shares 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 NAV occurs, authorized participants may buy or sell creation units to capture a profit. For example, when an ETF’s share price is above its NAV, authorized participants may find it profitable to deliver the creation basket of securities to the ETF in exchange for ETF shares that they may sell. When an ETF’s share price is below its NAV, authorized participants may find it profitable to return ETF shares to the fund in exchange for the ETF’s redemption basket of securities that they may sell. These actions by authorized participants help keep the market-determined price of an ETF’s shares close to its NAV.
As of year-end 2008, 728 exchange-traded funds were available to investors, compared with 80 funds at year-end 2000.
Demand for ETFs has accelerated as institutional investors have found ETFs a convenient vehicle for participating in, or hedging against, broad movements in the stock market. Retail investors and their financial advisers have become increasingly aware of these investment vehicles.
Increased investor demand for ETFs led to a rapid increase in the number of ETFs created by fund sponsors. Over the period from 2000 to 2008, there were 758 ETFs created, with the majority being offered in the last three years. Until 2008, few ETFs had been liquidated. In 2008, market pressures appeared to start coming into play as ETFs that track virtually identical indexes competed more vigorously against each other to gather assets. Also, some ETFs tied to niche indexes failed to generate enough investor interest. Although 50 ETFs were liquidated during 2008, the number of ETFs increased, on net, by nearly 100 to 728 at year-end 2008.
Net issuance of ETF shares continued to rise in 2008, reaching a record $177 billion. Assets in ETFs have grown rapidly over the past decade, with net issuance of ETF shares contributing to much of this increase. From year-end 1998 through 2008, ETFs issued $661 billion in net new shares, and investor demand for broad-based domestic equity ETFs accounted for about half of this total. These equity ETFs issued $336 billion in net new shares during this 10-year period, and their assets were $266 billion at year-end 2008. Within the broad-based domestic equity category, ETFs that track large cap domestic equity indexes, such as the S&P 500, managed $185 billion or 35 percent of all assets invested in ETFs.
An estimated 2 percent of U.S. households, or 2.3 million, owned ETFs in 2008. Of households that owned mutual funds, an estimated 4 percent also owned ETFs.
How big are ETF assets relative to all assets managed by mutual funds and other investment companies?
Assets in ETFs accounted for 5 percent of the $10.4 trillion total net assets managed by investment companies at year-end 2008.
Yes. Investor interest in global and international ETFs remained fairly strong in 2008 with net issuance amounting to $25 billion. In contrast, mutual funds that invested in foreign markets experienced substantial outflows in 2008. Over the period of 2004 to 2008, international and global ETFs issued $142 billion in net new shares; assets of these funds were $114 billion at the end of 2008.
As demand for ETFs has grown, ETF sponsors have offered more funds with a greater variety of investment objectives. In the mid-1990s, ETF sponsors introduced funds that invested in foreign stock markets. More recently, sponsors have introduced ETFs that invest in particular market sectors, industries, or commodities. At year-end 2008, there were 231 sector and commodity ETFs with $94 billion in assets. While commodity ETFs made up 19 percent of the number of sector and commodity ETFs, they accounted for 38 percent of total assets. Since their introduction in 2004, these nonregistered ETFs have grown from just over $1 billion to $36 billion by the end of 2008. Approximately three-quarters of commodity ETF assets tracked the price of gold and silver through the spot and futures markets in 2008. Sector ETFs that have proven to be popular with investors, both in terms of the number offered and assets gathered, are those focused on natural resources and financial institutions.
The Institute’s monthly statistical collection includes the combined assets of the nation’s exchange-traded funds (equity and bond ETFs), and the value of shares issued and redeemed. All ETFs registered as investment companies with the SEC, as well as nonregistered ETFs, are included in the statistical release. However, trust-issued receipts, such as Holding Company Depository Receipts (HOLDRS), are not included in the report. Statistics contained in the report have been obtained from information provided to ICI by exchange-traded funds.