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Exchange Traded Funds (or ETFs) have been available in the US since 1993 and in Europe from 1999. The idea of ETFs is to put funds and stock exchange trading into one product. Traditionally, funds or cash and stock exchange investments have been carefully kept apart to reflect liquidity issues. An ETF is a pool fund invested with a stated investment objective, for example, a tracker fund for the energy sector or geographical area. Shares owned in this fund by investors are in turn traded on an exchange.
While the first American ETFs were SPDRs, traded on the American Stock Exchange, the product has its genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the Amex and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States. Gastineau, Gary (2002). The Exchange-Traded Funds Manual. John Wiley and Sons, 32. ISBN 0471220922.
A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, proved to be popular. The popularity led the American Stock Exchange to try and develop something that would pass muster in the United States.
Nathan Most, an executive with the exchange, developed Standard & Poor\'s Depositary Receipts (SPDRs) which were introduced in January 1993. [Jennifer Bayot, Nathan Most Is Dead at 90; Investment Fund Innovator, New York Times, December 10, 2004] Morgan Stanley entered the fray in 1996 with World Equity Benchmark Shares (WEBS). While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind. Wiandt, Jim; William McClatchy (2002). Exchange Traded Funds. John Wiley and Sons, 82. ISBN 0471225134. Fabozzi, Frank (2003). The Handbook of Financial Instruments. John Wiley and Sons, 532. ISBN 0471220922.
The objective of an ETF is to participate in the economic growth of an industry or sector NOT available to the market in which the ETF is traded. Early US ETFs were set-up for example to participate in EU stocks or Companies. The performance of the fund is tracked by comparison to the growth index of the sector invested into. ETFs are distinct from UNIT TRUSTS and Investment Trusts. ETFs provide the attraction of the returns of a traditional tracker fund with the liquidity of a stock-exchange share.
Investor benefits of an ETF:
Investors in an ETF may not attend shareholder meetings of the underlying securities, as the investors own shares in the ETF, not the underlying securities. The cost of trading in ETFs shares is the same as other share dealing service charges, with the same dealing commission for trading ETFs as for other equities. Importantly, there is no Stamp Duty to pay on an ETF, as the fund managers have already paid duty when buying the underlying shares - there are no additional charges for the individual shareholder.
The first U.S. ETFs were based on broad market indexes; for example, "Spiders" (AMEX: SPY) (Standard & Poor\'s Depositary Receipts) is based on the S&P 500 index. Spiders is the largest ETF in the world. The index is determined by an independent company; for example, Spiders is run by State Street, while the S&P 500 is calculated by Standard & Poor\'s. Similarly, "Middies" (AMEX: MDY) is based on the S&P 400.
Next up were country funds (originally called "WEBS"). These allowed people to trade foreign markets as easily as U.S. stocks.
Fund companies also launched industry sector ETFs. In 1998, State Street Global Advisors introduced the "Sector Spiders" (website), which follow the nine sectors of the S&P 500.Ferri, Richard A. (2008). The ETF Book, John Wiley and Sons, 191 ISBN 0470130636
Since then, ETFs have moved in various directions. There are almost 700 U.S. funds existing (as of early 2008). Some funds became wildly popular almost overnight, some funds never attracted much interest, while many funds are somewhere in between.
Regional funds are popular; most investors do not need a separate fund for every country (iShares MSCI series has 22 country funds, and this still misses most countries). iShares MSCI EAFE (NYSE: EFA) and iShares MSCI Emerging Markets (NYSE: EEM) are the second- and third-largest ETFs in the world.
StreetTRACKS Gold Shares (NYSE: GLD) holds gold bullion. Its assets are about $19B (as of early 2008). Although it\'s registered as a grantor trust under the Securities Act of 1933 and not technically an ETF, the Gold Shares are still grouped together with ETFs. Most bond and equity ETFs are registred under the Investment Company Act of 1940.
Fund companies also launched ETFs based upon styles, such as "value" or "growth"; for example, iShares Russell 1000 Growth (NYSE: IWF) and iShares Russell 1000 Value (NYSE: IWD) split up the Russell 1000 index. Similar to this are funds based on dividends; for example, "Divvies" (NYSE: DVY) is based on the Dow Jones Select Dividend Index.
Bonds are another area that ETFs offer market exposure. Relatively few in number, some funds have gained respectable assets.
Major companies, such as Barclays Global Investors, State Street Global, and the Vanguard Group all offer a variety of fixed income ETFs. For example, each of these companies offer their own version of the Lehman Aggregate Bond Index, which is a popular bond benchmark. Barclays offers the iShares Lehman Aggregate Bond ETF (AMEX: AGG), State Street offers the SPDR Lehman Aggregate Bond ETF(AMEX: LAG), and Vanguard has the Total Bond Market Index ETF (AMEX: BND).
There are now inverse, leveraged, and inverse leveraged funds. These aim for daily returns of minus one, two, and minus two times the daily returns the relevant index.
In all cases, the SEC requires the index to be computed by a separate company.
ETFs in other localities have followed a similar progression: some "home" index (for example, Nikkei 225); some "foreign" index (for example, S&P 500); then perhaps various sectors.
ETFs may be set-up initially by simply raising the necessary cash for investment. Once up and running, rather than the fund manager dealing directly with shareholders, parties who have entered into a contract with the fund, such as institutional investors, and called Authorized Participants (APs) will create a basket of shares replicating or approximating the index, and deliver them to the fund in exchange for ETF shares. A basket, or creation unit, consists of anywhere from 10,000 ETF shares to 1,000,000 ETF shares.
ETF shares are then sold and resold freely among investors on the open market. If an investor accumulates a sufficient amount of ETF shares, he can exchange one full creation unit of ETF shares for a basket of the underlying shares of stock. The ETF creation unit is then redeemed and the underlying stocks delivered out of the fund.
Investors can profit from the difference in the share values of the underlying assets of the ETF and the trading price of the ETF\'s shares. ETF shares will trade at a premium to net asset value when demand is high and at a discount to net asset value when demand is low. In effect, the ETF is providing a system for arbitraging value in the market. As the initial costs are one-off, the ETF vehicle offers some cost advantages over other forms of pooled investment vehicles.
There is some confusion over terminology when referring to ETFs and other forms of pooled fund investments. For example, ETFs are highly flexible instruments for equalizing cash-flow. Money can be invested in an ETF that promises growth to achieve a higher rate of return than possible from other forms of investment available at the time. Since the ETFs shares are freely traded in an established market, you can sell when you require your money.
An actively managed ETF where the composition of the investments changes to achieve higher growth rates is entirely feasible and practised by a few funds. Observers draw analogies with mutual funds and seek to compare the two. Some have sought to bring the much older (and normally actively managed) investment trust class of fund under the ETF umbrella, pointing out that these are also funds that trade on exchanges. Real Estate Investment Trust units also commonly trade on exchanges and have properties similar to an ETF. The innovation of an ETFs does not exclude these other forms of investment vehicles in the market, nor restrict the potential application of ETFs to achieve different investor objectives in the market.
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[citation needed], therefore more likely to be proponents of indexing (a passive strategy). So it is not immediately obvious who would buy actively managed ETFs.
ETFs present an 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, boutique led criteria), fixed income, style (such as value and growth), industries, countries, precious metals, other commodities with more ideas being developed.
ETFs also enable people living outside the United States to participate in US based mutual funds. Traditional open-ended US mutual funds are available only to US residents, whereas anyone in the world can purchase shares in an ETF that trades on the open market.
As private banking moves towards a fee based model, the focus is shifting to asset allocation rather than stock selection. ETFs are a cheap and accessible way to populate asset allocation in client portfolios. Private bankers can focus on asset gathering for their clients.
Self-directed investors are following the lead taken by private bankers. A number of stock brokers report ETFs as their \'top-buys\' by client selection. Evidence that private investors are using ETFs to gain cost-effective exposure to specific investment strategies in volatile markets.
One reason for the slow uptake of ETFs in the UK has been the lack of a rebate commission, providing little incentive for advisors to promote them. However, 2006–2007 saw a sudden \'jump\' in ETFs activity as \'private\' wealth managers decided to participate in this market.
Early adopters of US ETFs were pensions funds, hedge funds and mutual funds. Wealth managers and self-directed investors followed. Today, more than half of ETFs in the US are held by retail investors.
One-third of European ETFs stock is in retail investors hands. There is every indication that the markets are heading the US way. In the UK, ETFs can be put into an Individual Savings Account [ISA].
First introduced by the TORONTO Stock Exchange, there are over four hundred ETFs traded on the US Stock Exchange. In other countries, there is varying momentum as the instrument is better understood and more ETFs registered for the advantages they offer. The US debut with SPY (launched by State Street Global Advisors and tracking the S&P 500) in 1993 has so far been an amazing success story.
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, often allowing for mitigation of taxes.
ETF managers BGI and State Street Global Advisors are the current leaders by assets under management, totaling 70% of the market.
ETFs trade on an exchange. Each transaction is subject to the broker\'s fee. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee, although a sales charge may apply if the mutual fund is loaded. Frequent transactions or for small amounts, trading ETFs can erode gains and thus make investing in a mutual fund more attractive. Where low or no-cost transactions are available, ETFs become very competitive.
ETFs trading is in the listed shares with the associated up-front trading costs for the investor. Other arrangements involve costs calculated to \'lay-off\' costs for management and administration of the fund. ETFs are therefore seen as transparent as for the investor, the risk lies in the movement in the value of the capital with dealing costs defined.
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 structured for tax efficiency and can be more attractive than mutual funds.
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. SEC Concept Release: Actively Managed Exchange-Traded Funds, Securities and Exchange Commission, Release No. IC-25258; File No. S7-20-01
However, there are some potential taxation drawbacks to ETFs in the United States. One argument made in favor of index mutual funds having a tax advantage over ETFs is that ETFs often trade their shares more rapidly to maintain a high cost basis of their underlying shares. This can result in ETF dividends failing to be classified as qualified dividends since the underlying shares don’t satisfy the IRS requirements. This can be a substantial drawback since your ordinary tax rate may be significantly higher than the 15% tax charged on qualified dividends.
In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account [ISA] or Self-invested personal pension [SIPP], in the same manner as many other shares.Bennett, Tim. ETFs: profit from the City’s best-kept secret. MoneyWeek, 15 February 2008
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).ETF Trading Order Basics http://www.etfguide.com/etfbasicordertypes.htm 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.
The ETFs available on exchanges vary from country to country. Many of the ETFs listed below are available exclusively on that nation\'s primary stock exchange and cannot be purchased on a foreign stock exchange. The American investor will not be able to buy these foreign ETFs on domestic exchanges. However, there do exist domestically traded ETFs that target various foreign, global, and regional indexes.
The first, and most widely held (as of 2007) US ETF is the Standard & Poor\'s Depositary Receipt, abbreviated SPDR. Shares of SPDR, called "spiders", are issued by State Street Global Advisors, and listed 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 DIA ("diamonds"), also issued by State Street Global Advisors.
Top US-based ETFs, by assets under management (October 2007):
In the European Union many ETFs are traded as cross border UCITS III funds. For example the UK iShares and ETF Securities are Irish registered UCITS funds and trade on the London Stock Exchange. Other ETF\'s are offered by 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.iShares ETFs for European investors - Exchange Traded Funds
In Sweden seven ETFs exist as of January 2008, all provided by XACT Fonder:
In Canada, Barclays Global Investors is the largest ETF provider, offering ETFs under the iShares brand name:
Claymore Investments also offers a series of ETFs available in Canada:
Horizons Betapro also offers a series of ETFs available in Canada:
All ROK-based ETFs, as of June 2006:
Sector ETFs may track sector-based indexes or simply correspond to a basket of companies thought to be representative of a specific market sector.
Country Specific ETFs
SPDR Sector ETFs
Van Eck Sector ETFs
PowerShares Sector ETFs (not exhaustive)
Horizons BetaPro Sector 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 [1]. 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.
The stated purpose of silver and gold ETFs are to track the price of gold and silver. They are NOT redeemable for the underlying instrument and unless rigid audit methods are put in place (and there is some debate about the silver ETFs (except ETFS Physical Silver that publishes on nwesbite and audits all bars) holdings as they do not provide audits) it is possible that there are not physical, serialized bullion physically backing the shares. They are also subject to increased volatility and they only represent a promise. If somebody defaults on that promise, the investor may not have anything to show for it thereby meaning they might have lost all of their investment. These concerns have done little to slow the popularity of precious metal ETFs. ETFS Physical Silver (PHAG LN) is backed by allocated metals and publishes all bar numbers with Platinum, Gold, Palladium as well.
Many etfs now correspond to bond indexes. Some popular ones include:
Typically ETFs track an index. Using a combination of options, futures, and swaps some firms have designed ETFs capable of tracking approximately -1x, 2x, and -2x the daily returns of an index. In the near future it is likely that ETFs with even higher leverage will emerge. These funds are structured in a sophisticated way and there is significant doubt as to whether or not these funds are appropriate vehicles for the casual investor.[3] (Note that obtaining 2x the daily returns for one year does not imply that one will receive double the annual returns of an index).
Short ETFs enable investors to profit from declines in an underlying index without directly selling short any securities. Investors who think an index will decline purchase shares of the short ETF that tracks the index, and the shares increase or decrease in value inversely with the index, that is to say that if the value of the underlying index goes down, then the value of the short ETF shares goes up, and vice versa. Some popular short ETFs include:
ProShares
Horizons BetaPro
ETF Securities
The following ETFs are good examples of Leveraged ETFs:
Proshares has many other leveraged ETFs targeting different styles, sectors, regions, and asset classes at their website ProShares ETFs
The following funds are both short and leveraged:
| 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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