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Letter from the ICI Research: Chapter 1: Chapter 2: Chapter 3: Chapter 5: Chapter 6: Chapter 7: |
What Is an ETF?An ETF is an investment company, typically an open-end investment company (open-end fund) or unit investment trust, whose shares are traded intraday on stock exchanges at market-determined prices. Investors may buy or sell ETF shares through a broker just as they would the shares of any publicly traded company. ETFs are a relatively recent innovation to the investment company concept. 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 a multiple of an inverse) of their indexes. In early 2008, the SEC first granted exemptive relief to several fund sponsors to offer fully transparent actively managed ETFs that meet certain 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, 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. Total Net Assets of ETFsBy the end of 2010, the total number of index-based and actively managed ETFs had grown to 923, and total net assets were $992 billion (Figure 3.1). Total Net Assets and Number of ETFs* Billions of dollars, year-end, 2000–2010
Download an Excel file of this data. *ETF data include ETFs not registered under the Investment Company Act of 1940; ETF data exclude ETFs that invest primarily in other ETFs.
The vast majority of assets in ETFs are in funds registered with and regulated by the SEC under the Investment Company Act of 1940 (Figure 3.2). At year-end 2010, about 10 percent of assets were held in ETFs that invest primarily in commodities, currency, and futures. These ETFs are not registered with or regulated by the SEC under the Investment Company Act of 1940. Nonregistered 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. Legal Structure of ETFs1 Percentage of total net assets, year-end 2010
Download an Excel file of this data. 1ETF data exclude ETFs that invest primarily in other ETFs. Creation of an ETFAn 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 and invests 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 an ETF that has a target index with thousands of securities in it. The sponsor of an actively managed ETF also determines the investment objective of the fund and may trade securities at its discretion, much like an actively managed mutual fund. In theory, an actively managed ETF could trade its portfolio securities regularly. In practice, however, most existing actively managed ETFs tend to trade only weekly or monthly for a number of reasons, including minimizing the risk of other market participants front-running their trades. ETFs are required to publish information about their portfolio holdings daily. Each business day, the ETF publishes a “creation basket,” a specific list of names and quantities of securities and/or other assets. The creation basket is either a replicate or a sample of the ETF’s portfolio. Actively managed ETFs and certain types of index-based ETFs are required to publish their complete portfolio holdings in addition to their creation basket. ETF shares are created when an “authorized participant”—typically a large institutional investor, such as a market maker or specialist—deposits the daily creation basket and/or cash with the ETF (Figure 3.3). The ETF may require or permit an authorized participant to substitute cash for some or all of the securities or assets in the creation basket. For instance, if a security in the creation basket is difficult to obtain or may not be held by certain types of investors (as is the case with certain foreign securities), the ETF may allow the authorized participant to pay that security’s portion of the basket in cash. An authorized participant may also be charged a transaction fee to offset any transaction expenses the fund undertakes. In return for the creation basket and/or cash, 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 an exchange. ETF shares are listed on a number of exchanges where investors can purchase them as they would shares of a publicly traded company. Creation of an ETF
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A creation unit is liquidated when an authorized participant returns the specified number of shares in the creation unit to the ETF. In return, the authorized participant receives the daily “redemption basket,” a set of specific securities and/or other assets contained within the ETF’s portfolio. The composition of the redemption basket typically mirrors that of the creation basket. ETFs and Mutual FundsA registered 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 and is governed by the Investment Company Act of 1940 like other mutual funds. For example, like a mutual fund, an ETF is required to post the mark-to-market net asset value (NAV) of its portfolio at the end of each trading day. Despite these similarities, key features differentiate ETFs from mutual funds. Key DifferencesOne major difference is that retail investors buy and sell ETF shares on a stock exchange through a broker-dealer, much like they would any other type of stock. In contrast, mutual fund shares are not listed on stock exchanges. Rather, retail investors buy and sell mutual fund shares through a variety of distribution channels, including through a financial adviser, broker-dealer, or directly from a fund company. Pricing also differs between mutual funds and ETFs. Mutual funds are “forward priced,” which means that although investors can place orders to buy or sell shares throughout the day, all orders placed during the day will receive the same price—the 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. How ETFs TradeThe 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 underlying value (i.e., the market value of the underlying instruments, also known as the Intraday Indicative Value or IIV), 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 underlying value: portfolio transparency and the ability for authorized participants to create or redeem ETF shares at NAV at the end of each trading day. The transparency of an ETF’s holdings enables investors to observe discrepancies between the ETF’s share price and its underlying value during the trading day and to attempt to profit from them. ETFs contract with third parties (typically market data vendors) to calculate an estimate of an ETF’s IIV, using the portfolio information an ETF publishes daily. IIVs are disseminated at regular intervals during the trading day (typically every 15 to 60 seconds). Some market participants for whom a 15- to 60-second latency is too long will use their own computer programs to estimate the underlying value of the ETF on a more real-time basis. If the ETF is trading at a discount to its underlying value, investors may buy ETF shares and/or sell the underlying securities. The increased demand for the ETF should raise its share price and the sales of the underlying securities should lower their share prices, narrowing the gap between the ETF and its underlying value. If the ETF is trading at a premium to its underlying value, investors may choose to sell the ETF and/or buy the underlying securities. These actions should reduce the ETF share price and/or raise the price of the underlying securities, bringing the price of the ETF and the market value of its underlying securities closer together. The ability of authorized participants to create or redeem ETF shares at the end of each trading day also helps an ETF trade at market prices that approximate the underlying market value of the portfolio. When a deviation between an ETF’s market price and its underlying value occurs, authorized participants may engage in trading strategies similar to those described above, but will purchase or sell creation units directly with the ETF. For example, when an ETF is trading at a premium, authorized participants may find it profitable to sell short the ETF during the day while simultaneously buying the underlying securities. At the end of the day, the authorized participant will deliver the creation basket of securities to the ETF in exchange for ETF shares that they use to cover their short sales. When an ETF is trading at a discount, authorized participants may find it profitable to buy the ETF shares and sell short the underlying securities. At the end of the day, authorized participants return ETF shares to the fund in exchange for the ETF’s redemption basket of securities that they use for their short positions. These actions by authorized participants, commonly described as “arbitrage opportunities,” help keep the market-determined price of an ETF’s shares close to its underlying value. Demand for ETFsIn the past decade, demand for ETFs has accelerated as institutional investors have found ETFs a convenient vehicle for participating in, or hedging against, broad movements in the stock market. Demand for ETFs also has been influenced by increased awareness of these investment vehicles by retail investors and their financial advisers. Assets in ETFs accounted for 8 percent of total net assets managed by investment companies at year-end 2010. Net issuance of ETF shares in 2010 amounted to $118 billion, about the same pace as in 2009 (Figure 3.4). Net Issuance of ETF Shares* Billions of dollars, 2000–2010
Download an Excel file of this data. *ETF data prior to 2001 were provided by Strategic Insight Simfund; ETF data include ETFs not registered under the Investment Company Act of 1940; ETF data exclude ETFs that invest primarily in other ETFs.
In 2010, investor demand for broad-based domestic equity ETFs rebounded, and demand for global and international ETFs remained strong (Figure 3.5). Broad-based domestic equity ETFs saw net issuance of $28 billion, after net redemptions of $12 billion in 2009. This reversal more than offset a decline in demand for domestic sector equity ETFs and commodity ETFs in 2010. Demand for bond and hybrid ETFs slowed as well with net issuance amounting to $30 billion in 2010, down from the record pace of $46 billion in 2009. Net issuance of global and international equity ETFs remained strong in 2010 at $42 billion, up from $40 billion in 2009. Net Issuance of ETF Shares1 by Investment Classification Billions of dollars, 2008–2010 Download an Excel file of this data. 1ETF data exclude ETFs that invest primarily in other ETFs.
Total Net Assets of ETFs1 Concentrated in Large-Cap Domestic Stocks Billions of dollars, year-end 2010
Download an Excel file of this data. 1ETF data exclude ETFs that primarily invest in other ETFs.
Increased investor demand for ETFs led to a rapid increase in the number of ETFs created by fund sponsors in the past decade (Figure 3.7). Over the period of 2000 to 2010, 1,055 ETFs were created with an average of almost 175 ETFs created per year in the past five years. Few ETFs had been liquidated until 2008 when market pressures appeared to come into play and sponsors began liquidating ETFs that had failed to gather sufficient assets. Liquidations have tended to occur among ETFs tracking virtually identical indexes, those focusing on specialty or niche indexes, or those using alternative weighting methodologies. Despite increasing liquidations over the period 2008 through 2010, the total number of ETFs also increased, on net, by 294 to a total of 923 over the same time frame. Number of ETFs1 2000–2010
Download an Excel file of this data. 1ETF data include ETFs not registered under the Investment Company Act of 1940. ETF data exclude ETFs that invest primarily in other ETFs.
As demand for ETFs has grown, ETF sponsors have offered more funds with a greater variety of investment objectives. Recently, sponsors have introduced ETFs that invest in particular market sectors, industries, or commodities. At year-end 2010, there were 248 sector and commodity ETFs with $205 billion in assets. While commodity ETFs only made up 22 percent of the number of sector and commodity ETFs (Figure 3.8), they accounted for 49 percent of the total net assets of these funds (Figure 3.9). Since their introduction in 2004, commodity ETFs have grown from just over $1 billion to $101 billion by the end of 2010, with total net assets almost tripling in the past two years. Strong net issuance and surging gold and silver prices were the primary drivers behind the increase in assets during this time. Approximately three-quarters of commodity ETF assets tracked the price of gold and silver through the spot and futures markets in 2010. Number of Commodity and Sector ETFs1 Percent, year-end 2010
Download an Excel file of this data. 1ETF data exclude ETFs that invest primarily in other ETFs. Total Net Assets of Commodity and Sector ETFs1 Percent, year-end 2010
Download an Excel file of this data. 1ETF data exclude ETFs that invest primarily in other ETFs.
In 2010, ETF sponsors continued building on recent innovations by launching additional actively managed ETFs and ETFs that are structured as funds of funds, both of which were first introduced in 2008. During 2010, seven actively managed ETFs were launched, bringing the total number of actively managed ETFs to 26* with nearly $3 billion in assets at year-end, excluding ETF funds of funds. ETF funds of funds are ETFs that hold and invest primarily in shares of other ETFs. At year-end 2010, there were 27 ETF funds of funds—including three actively managed ETF funds of funds that launched in 2010—with $1.3 billion in assets. Characteristics of ETF-Owning HouseholdsAn estimated 3.3 million U.S. households held ETFs in 2010. Of households that owned mutual funds, an estimated 5 percent also owned ETFs. ETF-owning households tended to include affluent, experienced investors who owned a range of equity and fixed-income investments. In 2010, 97 percent of ETF-owning households also owned stocks, either directly or through stock mutual funds or variable annuities (Figure 3.10). Sixty-six percent of households that owned ETFs also held bonds, bond mutual funds, or fixed annuities. In addition, 39 percent of ETF-owning households owned investment real estate. ETF-Owning Households Held a Broad Range of Investments Percentage of ETF-owning households holding each type of investment, May 2010*
Download an Excel file of this data. *Multiple responses are included.
Some characteristics of retail ETF owners are similar to those of retail stock owners because a large number of households that owned ETFs also owned stock. For instance, households that owned ETFs—like stock-owning households—tended to have household incomes above the national median and to own at least one defined contribution (DC) retirement plan account (Figure 3.11). However, ETF-owning households also exhibit some characteristics that distinguish them from stock-owning households. For example, ETF-owning households tended to have higher incomes, greater household financial assets, and to be headed by younger and college-educated individuals. Characteristics of ETF-Owning Households May 2010
Download an Excel file of this data. 1Total reported is household income before taxes in 2009.
For More InformationAvailable at www.ici.org. |
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