ETFs and index mutual funds are similar in that they both hold investment portfolios that match designated market indexes and attempt to achieve the same investment return as those market indexes. Investors—both retail and institutional—continue to turn to ETFs and index mutual funds as investment options in their portfolios. Although ETFs and index mutual funds have marked similarities, there remain key differences between the two types of investment products.

What Is an ETF?

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—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. By the end of 2006, the total number of ETFs had grown to 359 (Figure 3.1), and total assets reached nearly $423 billion (Figure 3.2).

Figure 3.1

Number of ETFs

(1993–2006)

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*ETFs not registered under the Investment Company Act of 1940
Sources: Investment Company Institute and Strategic Insight Simfund

Figure 3.2

Net Assets of ETFs

(millions of dollars, 1993–2006)

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*ETFs not registered under the Investment Company Act of 1940
Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute and Strategic Insight Simfund

An ETF originates with a sponsor, which chooses the ETF's target index, determines which securities will be included in the "basket" of securities, and decides how many ETF shares will be offered to investors. ETF shares are created when an institutional investor deposits with the ETF fund or trust a pre-specified basket of securities, identical or nearly identical in composition to the securities in the ETF's target index (Figure 3.3). In return for this basket of securities, the ETF issues to the institutional investor a "creation unit" that consists of a specified number of ETF shares. The institutional investor ("creation unit holder") 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 stock of a publicly traded company. A creation unit is liquidated when an institutional investor returns to the ETF the specified number of shares in the creation unit; in return, the institutional investor receives a basket of securities reflecting the current composition of the ETF.

Figure 3.3

Creation of an exchange-traded fund

The vast majority of ETFs are registered investment companies. In 2006, nearly 97 percent of total ETF assets were registered with the SEC under the Investment Company Act of 1940 (Figure 3.2). The remaining 3 percent of ETF assets, which are commodity-based, are not registered with or regulated by the SEC under the Investment Company Act of 1940. 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 not regulated by the CFTC.

Key Differences Between ETFs and Mutual Funds

ETFs and index mutual funds are both passively managed investment vehicles composed of the securities in their underlying indexes. As a result, the return of each type of fund tends to follow closely the return of its specific market index. Despite this similarity, key features differentiate ETFs and index mutual funds.

One difference is in how retail investors buy and sell shares. Retail investors canbuy and sell mutual fund shares through a variety of distribution channels, including through a broker-dealer or directly from a fund company. Also, mutual fund shares are not listed on stock exchanges. In contrast, retail investors can only buy or sell ETF shares on a stock exchange through a broker-dealer.

Pricing also differs between mutual funds and ETFs. For a mutual fund, the price at which investors buy and sell shares is equal to the fund's net asset value (NAV), less any commissions. The NAVs of both mutual funds and ETFs are calculated daily at the close of the markets. While investors can buy and sell mutual fund shares at any time throughout the day, all investors will receive the same transaction price (the NAV). 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 net asset value.

The price of an ETF share on a stock exchange is influenced by the forces of supply and demand. For example, when investor demand for an ETF increases, the ETF's share price will rise, perhaps exceeding the ETF's net asset value. ETFs are structured, however, so that large differences between their share prices and their NAVs are unlikely to persist. Third parties calculate and disseminate every 15 seconds a measure often called the Interday Indicative Value (IIV), which is a real-time estimate of a fund's NAV. When an ETF's share price is substantially above this indicative value, institutional investors may find it profitable to deliver the appropriate basket of securities to the ETF in exchange for ETF shares. Retail investors may find it profitable to take a short position in the ETF's shares. When an ETF's share price is substantially below its indicative value, institutional investors may find it profitable to return ETF shares to the fund in exchange for the ETF's basket of securities. Retail investors may find it profitable to take a long position in the ETF's shares. These actions by investors help keep the market-determined price of an ETF's shares close to the NAV of its underlying portfolio.

For more complete data on exchange-traded funds, see Section 2 in the Data Tables the Statistics and Research section of this site.

Demand for ETFs and Index Mutual Funds

By year-end 2006, assets in registered ETFs and index mutual funds reached a little more than $1.1 trillion, and accounted for 10 percent of the total assets managed by all registered investment companies. Over the past decade, assets in these indexed products have increased more than tenfold—with much of the growth occurring in funds that track broad market indexes. ETFs and index mutual funds that track large-blend domestic equity indexes, such as the S&P 500, now manage 40 percent of all assets invested in mutual funds and ETFs that focus on large-blend domestic stocks (Figure 3.4). ETFs and index funds are available in most other broad asset classes but, to date, have attracted less investor interest than those tied to indexes of large-blend domestic equity.

Figure 3.4

Assets of registered ETFs and Index Mutual Funds Are Concentrated in Large-Blend Domestic Equity

(billions of dollars, 2006)

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Sources: Investment Company Institute and Morningstar

Exchange-Traded Funds

Demand for ETFs has accelerated as retail investors and their financial advisers have become increasingly aware of these investment vehicles. Institutional investors, who find ETFs a convenient vehicle for participating in, or hedging against, broad movements in the stock market, have also bolstered the demand for exchange-traded funds.

As demand for ETFs has grown, ETF sponsors have offered more funds with a greater variety of investment objectives. In the mid-1990s, ETF sponsors introduced funds that invested in foreign stock markets. More recently, sponsors have introduced ETFs that invest in particular market sectors or industries. Fund companies introduced 67 sector/industry ETFs in 2006, and total net assets of these ETFs amounted to a little more than $58 billion (Figure 3.2). About one-third of the increase in assets of sector/industry ETFs during the past couple years is attributable to ETFs that track commodities. Assets of these nonregistered ETFs have grown briskly, from slightly more than $1 billion in 2004 to nearly $15 billion in 2006. In 2006, approximately 70 percent of nonregistered ETF assets tracked the price of gold through the spot and futures markets. ETFs that follow highly specialized indexes also are a very recent innovation. These ETFs accounted for approximately 10 percent of total net issuance of ETFs in 2006 and less than 3 percent of total assets at year-end.

Assets of ETFs have grown rapidly since the late 1990s, with net issuance of new ETF shares contributing to much of this increase. From year-end 1998 through 2006, ETFs issued $334 billion in net new shares, and investor demand for broad-based domestic equity funds accounted for much of the growth (Figure 3.5). These equity ETFs issued $187 billion in net new shares during this eight-year period, and their assets reached $232 billion by year-end 2006.

Figure 3.5

Net Issuance of ETF Shares

(millions of dollars, 1993–2006)

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*ETFs not registered under the Investment Company Act of 1940
Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute and Strategic Insight Simfund

Demand for global and international ETFs has also risen sharply in recent years, mirroring an increase in investor interest in mutual funds investing in foreign markets. International and global ETFs issued about $68 billion in net new shares over the period 2004 to 2006, and assets of these funds were $111 billion at the end of 2006.

Index Mutual Funds

Index mutual funds are also popular with investors. As of year-end 2006, 342 index funds (Figure 3.6) managed total assets of $749 billion (Figure 3.7). Demand for index mutual funds has remained fairly steady since 2000, with these funds attracting roughly between $25 billion and $40 billion in net new cash flow each year (Figure 3.8). In 2006, investors added $31 billion in new cash to index mutual funds, with most of the new money invested in funds indexed to domestic equity indexes other than the S&P 500. Funds indexed to the S&P 500 experienced outflows of $8 billion. As with ETFs, demand for global and international index funds also was strong, with investors allocating $10 billion in net new cash in these funds.

Figure 3.6

Number of Index mutual Funds

(1993–2006)

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Figure 3.7

Net Assets of Index mutual Funds

(millions of dollars, 1993–2006)

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Note: Components may not add to the total because of rounding.

Figure 3.8

Net New Cash Flow to Index mutual Funds

(millions of dollars, 1993–2006)

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Note: Components may not add to the total because of rounding.

Equity index funds account for the bulk of all index fund assets. About 90 percent of index mutual fund assets are invested in index funds that track either the S&P 500 index or other domestic and international equity indexes. Funds indexed to the S&P 500 manage 47 percent of all assets invested in index mutual funds. After ramping up fairly quickly in the latter half of the 1990s, the percentage of assets invested in equity index funds relative to all equity mutual fund assets has remained fairly steady between 12 and 13 percent for the past five years (Figure 3.9).

Figure 3.9

Equity Index mutual Fund Assets as a Percentage of Equity Mutual Fund Assets*

(percent, 1984–2006)

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*excludes funds of funds