Read an Excerpt

All About EXCHANGE-TRADED FUNDS

THE EASY WAY TO GET STARTED

The McGraw-Hill Companies, Inc.

Excerpt

Getting Started: A Primer on Exchange-Traded Funds

Exchange-traded funds (ETFs) have grown by over 1,000 percent during the 10-year period of 2001 to 2010. At the beginning of 2001, ETFs had combined assets under management (AuM) of approximately $70 billion with nearly 90 funds available in the U.S. marketplace. Fast-forward 10 years to the end of 2010 and AuM have ballooned to over $1 trillion with nearly 1,100 ETFs available in the marketplace. This is extraordinary growth that few ever predicted when the first ETFs were envisioned and launched only decades earlier. (See Figure 1-1 for a list of the 10 most actively traded U.S. ETFs.)

ETFs are a relatively recent innovation, but have become increasingly popular with casual, sophisticated, and institutional investors alike. ETFs offer shareholders, including those of moderate means, an opportunity to invest in a highly diversified, tax-efficient, and cost-effective basket of securities, such as common stocks, preferred stocks, bonds, real estate investment trusts (REITs), and commodities.

ETFs are not investment strategies; they are the basic structure, wrapper, or basket that contains the underlying securities. It is how the securities are managed that dictates an investment strategy or strategies. The same can be said for mutual funds and hedge funds, for that matter. However, each of the aforementioned investment structures offers unique features and characteristics not available—either partially or fully—in the other investment structures. To use an analogy, think of ETFs as a car in which the driver is the ETF provider, the passengers are the shareholders, the engine is the underlying securities, and the road map is the tracking index. A car only drives to where the driver steers it (i.e., the strategy). Cars do not drive themselves. However, not all cars are created the same. Some are faster than others, some are safer than others, some come with more conveniences, some hold more passengers, and some are considered more prestigious. Consequently, some types of investment structures (e.g., ETFs, mutual funds, hedge funds) make more sense for one strategy or shareholder but not for others.

When ETFs were initially created, they were designed to track market indexes much like the index mutual funds of the day. However, since 2008 when the first actively managed ETF was launched, most of the new ETFs have been designed to follow proprietary customized indexes. This essentially means that these ETFs are tossing aside the traditional index philosophy and incorporating active-management methodologies, all with the intent to outperform the market rather than generate market returns. Many ETF providers that emphasize active management claim their strategies—and therefore their ETFs—are better than all other ETFs in the marketplace. Perhaps the providers will even boast stellar performance to justify their claim. Smart investors know there is no Holy Grail of investing. Most money managers do not outperform their respective benchmarks in any given year, and those that do cannot outperform consistently over time. There will always be money managers who outperform and those who underperform. It's simple mathematics and the law of large numbers. However, where ETFs do add to the bottom line is in their unique structure that affords them favorable cost savings—namely, taxes, expenses, and trading efficiencies. These factors alone give ETFs built-in advantages and shareholders financial benefits and incentives.

WHAT IS AN ETF?

An ETF is an investment company organized under either the Securities Act of 1933 or the Investment Company Act of 1940 that offers shareholders a proportionate share in a portfolio of stocks, bonds, commodities, or other securities. From one perspective, ETFs can be considered a cross between common stocks and mutual funds whereby an ETF trades intraday on a stock exchange at continuously market-determined prices like common stocks and holds a diversified portfolio of securities like a traditional mutual fund. Mutual funds are "forward priced," meaning they can only be purchased and sold at the end of the trading session, whereas ETFs can be traded at any time the market is open for business. Additionally, ETFs offer stocklike tradability features such as selling short, purchasing via margin, and executing trades using market, limit, stop loss, and other discretionary order types.

One of the most important differences between ETFs and mutual funds is the price at which a shareholder can purchase or sell the fund. Mutual funds are transacted at marked-to-market net asset value (NAV), while ETFs are transacted at market-determined prices, which can differ from NAV. Although the market price for an ETF reflects the market values of the underlying securities, the market price on the fund level is also dictated by simple shareholder supply and demand. Thus, premiums or discounts to NAV can occur. Closed-end funds are much like ETFs in that closed-end funds trade on exchanges and hold pools of securities. However, closed-end funds trade with sometimes significant premiums or more typically discounts to NAV—sometimes as high as 30 percent.

Two features of an ETF's structure ensure that market prices approximate NAV. The first is transparency of holdings. When market participants know an ETF's holdings, they are far less likely to buy or sell at prices that deviate from the aggregate market value—called intraday indicative value (IIV)—associated with the holdings. Second, large institutional investors called authorized participants (APs) are contractually involved to buy or sell ETF shares in a continuous risk-free arbitragelike manner until the spread between the market price and NAV is negligible. Shareholders benefit from this arrangement as the ETF share price is aligned with its NAV, and APs benefit by making a small profit in the process.

As previously mentioned, ETFs are designed to track either market indexes or proprietary custom indexes. The decision about which index to track is up to the ETF provider. Before an ETF can be listed on an organized stock exchange, such as the NYSE Arca (which we will simply refer to as NYSE throughout this book), an ETF provider must receive approval from an appropriate legal entity. In the United States, approximately 90 percent of ETFs are approved and regulated by the Securities and Exchange Commission (SEC) and the remaining 10 percent by the Commodities Futures Trading Commission (CFTC). (See Figure 1-2 for a list of the 15 largest U.S. ETFs.)

How ETFs Operate

ETFs originate with ETF providers, such as Vanguard or PowerShares, which select an ETF's tracking index, establish the basket of securities underlying the ETF, and decide how many shares to offer to the investing marketplace. For instance, when an ETF provider selects an appropriate tracking index, that provider contracts with an AP to obtain the predetermined holdings that make up the basket of securities and to deposit them with the provider. In turn, the provider delivers to the AP what is called a "creation unit" typically representing between 50,000 and 100,000 ETF shares. APs can either hold the ETF shares or sell all or part of them on the open market, which are then purchased by you and me. Chapter 5 provides greater detail of this creation and redemption process.

As a result of the creation and redemption process, shareholders technically do not transact directly with an ETF provider—which is in contrast to mutual funds—and instead transact with APs. The SEC has mandated that ETF providers disclose this material fact in all their prospectuses and other client-approved written m
(Continues...)

---

Excerpted from All About EXCHANGE-TRADED FUNDS by SCOTT PAUL FRUSH. Copyright © 2012 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

---