Exchange-traded funds (ETFs) are investment companies that are legally classified as open-end companies or unit investment trusts (UITs) and that are similar to mutual funds or closed-ends funds except for a few differences. They are pooled investments that offer a return similar to that of an index. ETFs trade like an individual stock on major stock exchanges. The price of an ETF changes throughout the day just like a stock as it is bought and sold by investors. Unlike a mutual fund, ETFs do not have a NAV (Net Asset Value) that is calculated daily.
The differences include that ETFs do not sell individual shares directly to investors and only issue shares in large blocks called creation units; that after purchasing a creation unit, an investor often splits it up and sells the individual shares on a secondary market; and that investors buy creation units not with cash, but with a basket of securities that generally mirrors the ETF's portfolio.
Currently, all ETFs seek to achieve the same return as a particular market index. Such an ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index.
The American Stock Exchange (Amex) pioneered ETFs, bringing the first domestic ETF product -SPDRs, introduced by State Street Global Advisors - to market in 1993. Amex also formed Amex ETF Services, a wholly owned subsidiary of the exchange, to offer consulting on all aspects of ETFs to international exchanges and the investment management community.
How Do ETFs Work?
The issuer of an ETF is the trust or register investment company, commonly called the "fund" or the issuer. The fund’s investment objective, defined in the prospectus, will be to closely track the performance of a specified index or defined broad asset class. To achieve this, the fund will act according to the instructions provided by the investment adviser and/or the sponsor. The investment adviser or the sponsor will direct the fund to add and/or remove securities from the portfolio based on changes in the index.
ETFs are different from "closed-end funds" in many ways; one of the more important differences is that "closed-end" funds issue a finite number of shares. ETFs, however, are structured as open-end investment management companies or unit investment trusts - continuously issuing new shares and redeeming existing shares. This provides needed liquidity for the buy and sell sides of the market. However, these transactions with the fund itself may only be done in very large size transactions referred to as creation units, and are done by depositing with or receiving from the ETF the actual securities that are part of the index, not just cash. Because of their large size, these transactions are done by institutional investors, and they provide for an arbitrage between the price of the ETF on the exchange and the price at which an institution can create or redeem from the fund. It is this arbitrage situation that permits the ETF to avoid the kinds of discounts or premiums from net-asset value that are often seen.
Unlike traditional securities, ETFs are not subject to the uptick rule that prevents the short sale of securities on a downtick. This makes selling an ETF short much easier and quicker than with a traditional stock.
ETFs can be purchased through any brokerage account, both online and full service. A number of exchanges offer cash ETFs. For example, the American Stock Exchange lists ETFs on more than 180 broad stock market, stock industry sector, international stock, U.S. Treasury, and corporate bond indexes and commodities, and NYSE Arca lists 166.
There are 350 or more ETFs based on diverse sectors. The most popular (and most established historically) ETFs track indexes, which makes them quite similar to index-based mutual funds. Three ETFs established early on, which have gained investor and institutional attention are: the Nasdaq-100 Trust (QQQ), or Cubes, which tracks the Nasdaq 100 index; the Standard & Poor's Depositary Receipts (SPY), or Spiders, which track the S&P 500 index; and Diamonds (DIA), which track the Dow Jones Industrial Average (DJIA).
Options on ETFs
Option volume on all ETFs now accounts for nearly 70 percent of aggregate option volume while trading in actual ETFs account for approximately 30 percent of equity volume.
The Options Clearing Corporation provides a listing for each ETF option - symbol, expiration, strike, ticker for calls and puts, open interest and position limits, and exchanges offering the option - in a convenient spot online.
How Big Is the ETF Market?
As of 2016, the global ETF market accounts for about three per cent of assets under management (AUM), or $3.1 trillion. Two-thirds of the total, or about $2 trillion, is made up of U.S.-based funds.
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