Frequently Asked Questions About ETF Basics and Structure
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?
What is included in ICI’s monthly ETF report?
An exchange-traded fund (ETF) is a pooled investment vehicle with shares that trade intraday on stock exchanges at a market-determined price. 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 “authorized participants” or APs—typically, large financial institutions—providing a specified basket of securities, cash, or both—often called a “creation basket”—to the ETF. In return, the AP 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 AP 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 AP, 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 have been available as an investment product for a little more than 20 years in the United States. 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 2014, the total number of index-based and actively managed ETFs had grown to 1,411, and total net assets were $1,974 billion. Of these, 111 were actively managed ETFs with $16.5 billion 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 3 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 the Securities Act of 1933.
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 ETFs that track indexes containing securities that are too numerous (such as broad-based or total stock market indexes), that have restrictions on ownership or transferability (certain foreign securities), or that are difficult to obtain (some fixed-income 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. For instance, the sponsor may try to achieve an investment objective such as outperforming a segment of the market or investing in a particular sector through a portfolio of stocks, bonds, or other assets.
Each business day, ETFs are required to make available a portfolio composition file that describes the makeup of their “creation and redemption baskets”—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 and redemption baskets are 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 and redemption baskets.
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 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 NAV: portfolio transparency and the ability for APs to create or redeem ETF shares at NAV at the end of each trading day.
Transparency of an ETF’s holdings—either through full disclosure of the portfolio or through established relationships of the components of the ETF’s portfolio with published indexes, financial or macroeconomic variables, or other indicators—enables investors to observe and attempt to profit from discrepancies between the ETF’s share price and its underlying value during the 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). IIVs are disseminated at regular intervals during the trading day (typically every 15 seconds. APs, market makers, and other institutional investors also can make this assessment in real time using their own computer programs and proprietary data feeds.
When there are discrepancies between an ETF’s share price and the value of its underlying securities, trading can more closely align the ETF’s price and its underlying value. For example, if an ETF is trading at a discount to its underlying value, investors may buy shares and/or sell the underlying securities. This change in demand for the ETF shares and the underlying securities should alter their respective prices and narrow the gap between the ETF share price and its underlying value.
The ability of APs to create or redeem ETF shares at the end of the trading day also helps an ETF trade at market prices that approximate the underlying market value of its 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 is trading at a premium, APs may find it profitable to sell short the ETF during the day while simultaneously buying the underlying securities. APs then deliver the creation basket of securities to the ETF in exchange for ETF shares that they use to cover their short sales. These actions by APs, commonly described as arbitrage opportunities, help keep the market-determined price of an ETF’s shares close to its underlying value.
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. Statistics contained in the report have been obtained from information provided to ICI by exchange-traded funds.