How does an ETF investment work?

by: Daniel Webb

What is an exchange-traded fund (ETF)?

An ETF Investment is an exchange-traded fund, a type of investment vehicle traded on stock exchanges. ETF stocks are traded like single shares, with the prices moving throughout the day.

An ETF characteristically holds assets such as stocks (usually an assortment of investments in unit trusts and investment trusts) or bonds. Many ETFs in fact track an overall index, such as the S&P 500 or MSCI EAFE. An ETF’s overall value is usually around the same price as the net value of the asset value of its underlying assets; if it is tracking an overall index, its value typically moves in line with changes in that index. Only “authorized participants” (typically large investors) are actually permitted to deal directly with the ETF in terms of buying or selling shares from or to the fund manager. Such dealings typically involve the acquisition or sale of “creation units” (i.e. groups of tens of thousands of ETF shares. Individual investors then go through these “authorised participants” to buy ETF stocks and to formulate their ETF trading strategies.

How long have ETFs been around?

ETF’s are a comparatively recent product, having been available in the US only since 1993. In 1992, the American Stock Exchange (AMEX) made use of the SEC’s “SuperTrust Order” to request use of the first authorized ETF. The SEC granted that petition, and established the SPDR Order in October, 1992, allowing the AMEX to consequently list the S&P Depositary Receipts, Trust Series 1 (aka “Spider”) (which was benchmarked to the Standard & Poors’ 500 Index) the following year. ETFs came to Europe a few years later, in 1999. (In the US, in addition to “Spiders”, new ETFs followed benchmarks like the Dow Jones Industrial Average (DIAMONDS Trust Series 1 (“Diamonds”), and the NASDAQ (NASDAQ 100 Index Tracking Stock (“Cubes”) followed in 1998 and 1999 respectively..)

As such, ETF’s have to date been mainly what might be called “index funds” which track entire indexes (as above). While, during their short history to date, ETFs have traditionally been the domain of large and/or offshore investors, with private investors reluctant to trade in them, this trend is changing. Now private investors account for approximately 40 percent of ETF trades in the US, a proportion that seems set to rise. One cause that private investors have become more concerned in ETFs is that they offer access to funds that track assets and sectors that were earlier only obtainable to bigger investors.

Types of ETF Investments available

Since their initial launch, a number of different types of ETF have developed in the market place. These include Open-end index funds (products include iShares, Select Sector SPDRs, PowerShares, Vanguard, and WisdomTree), Unit Investment Trusts (UITs) (products include BLDRs, Diamonds, SPDRs, and PowerShares QQQ Trust ), Grantor Trusts (products include Currency Shares, streetTRACKS Gold Shares, iShares Silver Trust, and Merrill Lynch HOLDRs), Exchange-traded Notes (ETNs) (products include iPath ETNs, ELEMENTS ETNs) and Partnerships (products include U.S. Oil). (Source: EFTGuide.com). In 2003 assets held by ETFs in the US alone exceeded US$155 Billion.

To comprehend whether ETF investment is appropriate for you and in selecting as to which specific vehicle to comprise in your portfolio, it is crucial that you know, among other things, its pros and cons.

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