Exchange-traded grantor trusts
An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRS, a proprietary Merrill Lynch product. HOLDRS are neither index funds nor actively-managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRS have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRS to be a separate product from ETFs.[7][23]
[edit] Hedge Fund ETFs
Hedge fund ETFs are a new type of an ETF. A hedge fund ETF tracks a hedge fund and follow a group of hedge fund's activity. These new Hedge Fund ETF's are offered by IndexIQ they include IQ Hedge Multi-Strategy Composite, IQ Hedge Global Macro, IQ Hedge Long/Short Equity, IQ Hedge Event-Driven and IQ Hedge Market Neutral
Each of these hedge fund ETF's follows a general hedge fund strategy (Event-Driven, Market Neutral ect...).[24]
[edit] Leveraged ETFs
A leveraged exchange-traded fund, or simply leveraged ETF, is a special type of ETF that attempts to achieve returns that are more sensitive to market movements than a non-leveraged ETF.[25] Leveraged index ETFs are often marketed as bull or bear funds. A bull ETF fund might for example attempt to achieve daily returns that are 2.0 times more pronounced than the Dow Jones Industrial Average or the S & P 500. A bear fund on the other hand may attempt to achieve returns that are -2.0 times the daily index return, meaning that it will gain twice the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return.[26]. The most common way to construct leveraged ETFs is by trading future contracts.
History
Massachusetts Investors Trust (now MFS Investment Management) was founded on March 21, 1924, and, after one year, it had 200 shareholders and $392,000 in assets. The entire industry, which included a few closed-end funds represented less than $10 million in 1924.
The stock market crash of 1929 hindered the growth of mutual funds. In response to the stock market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require that a fund be registered with the Securities and Exchange Commission (SEC) and provide prospective investors with a prospectus that contains required disclosures about the fund, the securities themselves, and fund manager. The SEC helped draft the Investment Company Act of 1940, which sets forth the guidelines with which all SEC-registered funds today must comply.
With renewed confidence in the stock market, mutual funds began to blossom. By the end of the 1960s, there were approximately 270 funds with $48 billion in assets. The first retail index fund, First Index Investment Trust, was formed in 1976 and headed by John Bogle, who conceptualized many of the key tenets of the industry in his 1951 senior thesis at Princeton University[2]. It is now called the Vanguard 500 Index Fund and is one of the world's largest mutual funds, with more than $100 billion in assets.
A key factor in mutual-fund growth was the 1975 change in the Internal Revenue Code allowing individuals to open individual retirement accounts (IRAs). Even people already enrolled in corporate pension plans could contribute a limited amount (at the time, up to $2,000 a year). Mutual funds are now popular in employer-sponsored "defined-contribution" retirement plans such as (401(k)s) and 403(b)s as well as IRAs including Roth IRAs.
As of October 2007, there are 8,015 mutual funds that belong to the Investment Company Institute (ICI), a national trade association of investment companies in the United States, with combined assets of $12.356 trillion.[3] In early 2008, the worldwide value of all mutual funds totaled more than $26 trillion.[4]
Usage
Since the Investment Company Act of 1940, a mutual fund is one of three basic types of investment companies available in the United States.[5]
Mutual funds can invest in many kinds of securities. The most common are cash instruments, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as technology or utilities. These are known as sector funds. Bond funds can vary according to risk (e.g., high-yield junk bonds or investment-grade corporate bonds), type of issuers (e.g., government agencies, corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and foreign securities (global funds), or primarily foreign securities (international funds).
Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts cash flows into and out of the fund by investors, as well as the future performance of investments appropriate for the fund and chooses those which he or she believes will most closely match the fund's stated investment objective. A mutual fund is administered under an advisory contract with a management company, which may hire or fire fund managers.
Mutual funds are subject to a special set of regulatory, accounting, and tax rules. In the U.S., unlike most other types of business entities, they are not taxed on their income as long as they distribute 90% of it to their shareholders and the funds meet certain diversification requirements in the Internal Revenue Code. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are tax-free to the shareholder. Taxable distributions can be either ordinary income or capital gains, depending on how the fund earned those distributions. Net losses are not distributed or passed through to fund investors.
Net asset value
Main article: Net asset value
The net asset value, or NAV, is the current market value of a fund's holdings, less the fund's liabilities, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but some funds update their NAV multiple times during the trading day. The public offering price, or POP, is the NAV plus a sales charge. Open-end funds sell shares at the POP and redeem shares at the NAV, and so process orders only after the NAV is determined. Closed-end funds (the shares of which are traded by investors) may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus.
Average Annual Return
US mutual funds use SEC form N-1A to report the average annual compounded rates of return for 1-year, 5-year and 10-year periods as the "average annual total return" for each fund. The following formula is used:[6]
P(1+T)n = ERV
Where:
P = a hypothetical initial payment of $1,000.
T = average annual total return.
n = number of years.
ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).
Turnover
Turnover is a measure of the fund's securities transactions, usually calculated over a year's time, and usually expressed as a percentage of net asset value.
This value is usually calculated as the value of all transactions (buying, selling) divided by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and another one bought as one "turnover". Thus turnover measures the replacement of holdings.
In Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is calculated based on the lesser of purchases or sales divided by the average size of the portfolio (including cash).
Monday, July 20, 2009
ETF
An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.[1][2]
Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from/to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets.[3] Other investors, such as individuals using a retail brokerage, trade ETF shares on this secondary market.
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs.[3]
Structure
ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units." Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.[3]
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.[3] If there is strong investor demand for an ETF, its share price will (temporarily) rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares increases the ETF's market capitalization and reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF and its shares trade at a discount from net asset value.
In the United States, most ETFs are structured as open-end management investment companies (the same structure used by mutual funds and money market funds), although a few ETFs, including some of the largest ones, are structured as unit investment trusts. ETFs structured as open-end funds have greater flexibility in constructing a portfolio and are not prohibited from participating in securities lending programs or from using futures and options in achieving their investment objectives.[4] Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. In 2008, however, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders. Under the SEC proposal, an ETF would be defined as a registered open-end management investment company that:
* Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated on a per share basis by a national securities exchange at regular intervals during the trading day;
* Identifies itself as an ETF in any sales literature;
* Issues shares that are approved for listing and trading on a securities exchange;
* Discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and
* Either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund.[3]
The SEC rule proposal would allow ETFs either to be index funds or to be fully transparent actively managed funds. Historically, all ETFs in the United States have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust,[5] and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on 25 March 2008.[6] The SEC rule proposal indicates that the SEC is not suggesting that it will not consider future applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rule's transparency requirements.[3]
Some ETFs invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not "investment companies" under the Investment Company Act of 1940.[3]
Publicly traded grantor trusts, such as Merrill Lynch's HOLDRS securities, are sometimes considered to be ETFs, although they lack many of the characteristics of other ETFs. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not "investment companies" under the Investment Company Act of 1940.[7]
History
ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange 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.[8]
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 of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.[8]
Nathan Most, an executive with the exchange, developed Standard & Poor's Depositary Receipts (AMEX: SPY), which were introduced in January 1993.[9] Known as SPDRs or "Spiders," the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (AMEX: MDY).
Barclays Global Investors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indexes, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.[10] [11]
In 1998, State Street Global Advisors introduced the "Sector Spiders", which follow the nine sectors of the S&P 500.[12] In 1999, the influential "cubes" (NASDAQ: QQQQ) were launched.
Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of May 2008, there were 680 ETFs in the U.S., with $610 billion in assets, an increase of $125 billion over the previous twelve months.[13]
Investment uses
ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies.[4] Among the advantages of ETFs are the following:[7][14]
* Lower costs - ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.
* Buying and selling flexibility - ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.
* Tax efficiency - ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.
* Market exposure and diversification - ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.
* Transparency - ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.
Some of these advantages derive from the status of most ETFs as index funds.
Types of ETFs
Index ETFs
Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index. [4] Some index ETFs, known as leveraged ETFs or short ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.[15] As of February 2008, index ETFs in the United States included 415 domestic equity ETFs, with assets of $350 billion; 160 global/international equity ETFs, with assets of $169 billion; and 53 bond ETFs, with assets of $40 billion.[16]
Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication." Other index ETFs use "representative sampling," investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. For index ETFs that invest in indexes with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.[17]
Commodity ETFs or ETCs (Exchange Traded Commodities)
Commodity ETFs invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003. Commodity ETFs generally are index funds, but track non-securities indexes. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.[18]
Exchange Traded Commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to Exchange Traded Funds (ETFs) and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on-Exchange, during market hours.
ETCs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent; for example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the non-professional investor is the method that these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.
Bond ETFs
Exchange-traded funds that invest in U.S. Government bonds -- like the iShares Barclays 20+ Year Treasury Bond Fund, [NYSE: TLT], are known as Bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into U.S. Treasuries. Because of this cause and effect relationship, the performance of Bond ETFs may be indicative of broader economic conditions.[19] There are several advantages to Bond ETFs such as the reasonable trading commissions they generate, but this benefit can be negatively offset by trading fees if bought and sold through a third party.[20]
Currency ETFs
In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London.
Actively managed ETFs
Actively managed ETFs are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it is willing to consider allowing actively managed ETFs that are not fully transparent in the future.[3]
The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front-run its trades[citation needed]. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.[21]
The initial actively managed ETFs have received a lukewarm response and have been far less successful at gathering assets than were other novel ETFs. Among the reasons suggested for the initial lack of market interest are the steps required to avoid front-running, the time needed to build performance records, and the failure of actively managed ETFs to give investors new ways to make hard-to-place bets.[22]
Exchange-traded grantor trusts
An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRS, a proprietary Merrill Lynch product. HOLDRS are neither index funds nor actively-managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRS have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRS to be a separate product from ETFs.[7][23]
Hedge Fund ETFs
Hedge fund ETFs are a new type of an ETF. A hedge fund ETF tracks a hedge fund and follow a group of hedge fund's activity. These new Hedge Fund ETF's are offered by IndexIQ they include IQ Hedge Multi-Strategy Composite, IQ Hedge Global Macro, IQ Hedge Long/Short Equity, IQ Hedge Event-Driven and IQ Hedge Market Neutral
Each of these hedge fund ETF's follows a general hedge fund strategy (Event-Driven, Market Neutral ect...).[24]
Leveraged ETFs
A leveraged exchange-traded fund, or simply leveraged ETF, is a special type of ETF that attempts to achieve returns that are more sensitive to market movements than a non-leveraged ETF.[25] Leveraged index ETFs are often marketed as bull or bear funds. A bull ETF fund might for example attempt to achieve daily returns that are 2.0 times more pronounced than the Dow Jones Industrial Average or the S & P 500. A bear fund on the other hand may attempt to achieve returns that are -2.0 times the daily index return, meaning that it will gain twice the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return.[26]. The most common way to construct leveraged ETFs is by trading future contracts.
Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from/to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets.[3] Other investors, such as individuals using a retail brokerage, trade ETF shares on this secondary market.
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs.[3]
Structure
ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units." Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.[3]
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.[3] If there is strong investor demand for an ETF, its share price will (temporarily) rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares increases the ETF's market capitalization and reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF and its shares trade at a discount from net asset value.
In the United States, most ETFs are structured as open-end management investment companies (the same structure used by mutual funds and money market funds), although a few ETFs, including some of the largest ones, are structured as unit investment trusts. ETFs structured as open-end funds have greater flexibility in constructing a portfolio and are not prohibited from participating in securities lending programs or from using futures and options in achieving their investment objectives.[4] Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. In 2008, however, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders. Under the SEC proposal, an ETF would be defined as a registered open-end management investment company that:
* Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated on a per share basis by a national securities exchange at regular intervals during the trading day;
* Identifies itself as an ETF in any sales literature;
* Issues shares that are approved for listing and trading on a securities exchange;
* Discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and
* Either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund.[3]
The SEC rule proposal would allow ETFs either to be index funds or to be fully transparent actively managed funds. Historically, all ETFs in the United States have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust,[5] and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on 25 March 2008.[6] The SEC rule proposal indicates that the SEC is not suggesting that it will not consider future applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rule's transparency requirements.[3]
Some ETFs invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not "investment companies" under the Investment Company Act of 1940.[3]
Publicly traded grantor trusts, such as Merrill Lynch's HOLDRS securities, are sometimes considered to be ETFs, although they lack many of the characteristics of other ETFs. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not "investment companies" under the Investment Company Act of 1940.[7]
History
ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange 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.[8]
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 of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.[8]
Nathan Most, an executive with the exchange, developed Standard & Poor's Depositary Receipts (AMEX: SPY), which were introduced in January 1993.[9] Known as SPDRs or "Spiders," the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (AMEX: MDY).
Barclays Global Investors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indexes, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.[10] [11]
In 1998, State Street Global Advisors introduced the "Sector Spiders", which follow the nine sectors of the S&P 500.[12] In 1999, the influential "cubes" (NASDAQ: QQQQ) were launched.
Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of May 2008, there were 680 ETFs in the U.S., with $610 billion in assets, an increase of $125 billion over the previous twelve months.[13]
Investment uses
ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies.[4] Among the advantages of ETFs are the following:[7][14]
* Lower costs - ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.
* Buying and selling flexibility - ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.
* Tax efficiency - ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.
* Market exposure and diversification - ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.
* Transparency - ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.
Some of these advantages derive from the status of most ETFs as index funds.
Types of ETFs
Index ETFs
Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index. [4] Some index ETFs, known as leveraged ETFs or short ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.[15] As of February 2008, index ETFs in the United States included 415 domestic equity ETFs, with assets of $350 billion; 160 global/international equity ETFs, with assets of $169 billion; and 53 bond ETFs, with assets of $40 billion.[16]
Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication." Other index ETFs use "representative sampling," investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. For index ETFs that invest in indexes with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.[17]
Commodity ETFs or ETCs (Exchange Traded Commodities)
Commodity ETFs invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003. Commodity ETFs generally are index funds, but track non-securities indexes. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.[18]
Exchange Traded Commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to Exchange Traded Funds (ETFs) and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on-Exchange, during market hours.
ETCs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent; for example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the non-professional investor is the method that these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.
Bond ETFs
Exchange-traded funds that invest in U.S. Government bonds -- like the iShares Barclays 20+ Year Treasury Bond Fund, [NYSE: TLT], are known as Bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into U.S. Treasuries. Because of this cause and effect relationship, the performance of Bond ETFs may be indicative of broader economic conditions.[19] There are several advantages to Bond ETFs such as the reasonable trading commissions they generate, but this benefit can be negatively offset by trading fees if bought and sold through a third party.[20]
Currency ETFs
In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London.
Actively managed ETFs
Actively managed ETFs are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it is willing to consider allowing actively managed ETFs that are not fully transparent in the future.[3]
The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front-run its trades[citation needed]. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.[21]
The initial actively managed ETFs have received a lukewarm response and have been far less successful at gathering assets than were other novel ETFs. Among the reasons suggested for the initial lack of market interest are the steps required to avoid front-running, the time needed to build performance records, and the failure of actively managed ETFs to give investors new ways to make hard-to-place bets.[22]
Exchange-traded grantor trusts
An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRS, a proprietary Merrill Lynch product. HOLDRS are neither index funds nor actively-managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRS have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRS to be a separate product from ETFs.[7][23]
Hedge Fund ETFs
Hedge fund ETFs are a new type of an ETF. A hedge fund ETF tracks a hedge fund and follow a group of hedge fund's activity. These new Hedge Fund ETF's are offered by IndexIQ they include IQ Hedge Multi-Strategy Composite, IQ Hedge Global Macro, IQ Hedge Long/Short Equity, IQ Hedge Event-Driven and IQ Hedge Market Neutral
Each of these hedge fund ETF's follows a general hedge fund strategy (Event-Driven, Market Neutral ect...).[24]
Leveraged ETFs
A leveraged exchange-traded fund, or simply leveraged ETF, is a special type of ETF that attempts to achieve returns that are more sensitive to market movements than a non-leveraged ETF.[25] Leveraged index ETFs are often marketed as bull or bear funds. A bull ETF fund might for example attempt to achieve daily returns that are 2.0 times more pronounced than the Dow Jones Industrial Average or the S & P 500. A bear fund on the other hand may attempt to achieve returns that are -2.0 times the daily index return, meaning that it will gain twice the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return.[26]. The most common way to construct leveraged ETFs is by trading future contracts.
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