This chapter provides an overview of exchange-traded funds (ETFs)—how they are created, how they trade, how they differ from mutual funds, the demand by investors for ETFs, and the characteristics of ETF-owning households.

For investors seeking to gain or shed exposure to broad market indexes, particular sectors or geographical regions, or specific rules-based investment strategies, ETFs are a convenient, cost-effective tool. Over the past decade, demand for ETFs has grown markedly as investors—both institutional and retail—increasingly turn to them as investment options. In the past 10 years, nearly $1.6 trillion of net new ETF shares have been issued. With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives. With $2.1 trillion in assets, the U.S. ETF industry remained the largest in the world at year-end 2015. Though ETFs share some basic characteristics with mutual funds, there are key operational and structural differences between the two types of investment products.

What Is an ETF? 

An ETF is a pooled investment vehicle with shares that investors can buy and sell throughout the day on a stock exchange 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. In the United States, most ETFs are structured as open-end investment companies, like mutual funds, and governed by the same regulations. Other ETFs—primarily those investing in commodities, currencies, and futures—have different structures and are subject to different regulatory requirements.

ETFs have been available as an investment product for more than 20 years in the United States. The Securities and Exchange Commission (SEC) approved the first ETF—a broad-based domestic equity fund tracking the S&P 500 index—in 1993. Until 2008, the SEC only approved ETFs that tracked specified indexes. These ETFs, commonly referred to as index-based ETFs, are designed to track the performance of their designated 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 granted approval to several fund sponsors to offer fully transparent, actively managed ETFs meeting certain requirements. Each business day, these actively managed ETFs must disclose 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 adviser to an actively managed mutual fund, creates a unique mix of investments to meet a particular investment objective and policy. At year-end 2015, 134 actively managed ETFs—with nearly $28 billion in assets—were registered with the SEC as investment companies.

ETFs and Mutual Funds 

An ETF is a registered investment company that is similar to a mutual fund because it offers investors a proportionate share in a pool of stocks, bonds, and other assets. 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 and must conform to the main investor protection mechanisms of the Investment Company Act, including limitations on leverage, daily valuation and liquidity requirements, prohibitions on transactions with affiliates, and rigorous disclosure obligations. Also like mutual funds, creations and redemptions of ETF shares are aggregated and executed just once per day at NAV. Despite these similarities, key features differentiate ETFs from mutual funds.

Key Differences 

One major difference is that retail investors buy and sell ETF shares on the secondary market (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, but are purchased and sold through a variety of distribution channels, including through investment professionals—full-service brokers, independent financial planners, bank or savings institution representatives,
or insurance agents—or directly from a fund company or discount broker.

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 on the secondary market may not necessarily equal the NAV of the portfolio of securities in the ETF. 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, which—like a mutual fund—is calculated as of 4:00 p.m. eastern time.

U.S. ETF Assets 

The U.S. ETF market—with 1,594 funds and $2.1 trillion in assets under management at year-end 2015—remained the largest in the world, accounting for 72 percent of the $2.9 trillion in ETF assets worldwide (Figure 3.1 and Figure 3.2).

The vast majority of assets in U.S. ETFs are in funds registered with and regulated by the SEC under the Investment Company Act of 1940 (Figure 3.2). At year-end 2015, about 2 percent of assets were held in ETFs that are not registered with or regulated by the SEC under the Investment Company Act of 1940 (non–1940 Act ETFs); these ETFs invest primarily in commodities, currencies, and futures. Non–1940 Act ETFs that invest in commodity or currency futures are regulated by the Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act and by the SEC under the Securities Act of 1933. Those that invest solely in physical commodities or currencies are regulated by the SEC under the Securities Act of 1933.

Figure 3.1

The United States Has the Largest ETF Market

Percentage of total net assets, year-end 2015

Figure 3.1

 

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Sources: Investment Company Institute and ETFGI


Figure 3.2

Total Net Assets and Number of ETFs

Billions of dollars; year-end, 2006–2015

Figure 3.2

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1The funds in this category are not registered under the Investment Company Act of 1940 and invest primarily in commodities, currencies, and futures.
2The funds in this category are registered under the Investment Company Act of 1940.
Note: Data for ETFs that invest primarily in other ETFs are excluded from the totals. Components may not add to the total because of rounding.

Origination of an ETF 

An ETF originates with a sponsor—a company or financial institution—that 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 various ways. Many early ETFs tracked traditional indexes, mostly those weighted by market capitalization. More-recently launched index-based ETFs follow benchmarks that use an array of index construction methodologies, with weightings based on market capitalization, as well as other fundamental factors, such as sales or book value. Others follow factor-based metrics—indexes that first screen potential securities for a variety of attributes, including value, growth, or dividend payments—and then weight the selected securities equally or by market capitalization. Other customized index approaches include screening, selecting, and weighting securities to minimize volatility, maximize diversification, or achieve a high or low degree of correlation with the market.

An index-based ETF may replicate its index (that is, it may invest 100 percent of its assets proportionately in all the securities in the target index) or it may sample its index by investing in a representative sample of securities in the target index. Representative sampling is a practical solution for ETFs that track indexes containing thousands of securities (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 objective 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.

Creation and Redemption of ETF Shares—Primary Market Activity 

The creation or redemption of ETF shares is categorized as primary market activity. The creation/redemption mechanism in the ETF structure allows the number of shares outstanding in an ETF to expand or contract based on demand (Figure 3.3). Each business day, ETFs are required to publish the creation and redemption baskets for the next trading day. The creation/redemption baskets are specific lists of names and quantities of securities, cash, and/or other assets. Often baskets will track the ETF’s portfolio through either a pro rata slice or a representative sample, but, at times, baskets may be limited to a subset of the ETF’s portfolio and contain a cash component. For example, the composition of baskets for bond ETFs may vary day to day with the mix of cash and the selection of bonds in the baskets based on liquidity in the underlying bond market. Typically, the composition of an ETF’s daily creation and redemption baskets mirror one another.

Creation

ETF shares are created when an authorized participant, or AP, submits an order for one or more creation units. A creation unit consists of a specified number of ETF shares, generally ranging from 25,000 to 250,000 shares. The ETF shares are delivered to the AP when the specified creation basket is transferred to the ETF. The ETF may permit or require an AP to substitute cash for some or all of the securities or assets in the creation basket, particularly when an instrument in the creation basket is difficult to obtain or may not be held by certain types of investors (such as certain foreign securities). An AP also may be charged a cash adjustment and/or transaction fee to offset any transaction expenses the fund undertakes. The value of the creation basket and any cash adjustment equals the value of the creation unit based on the ETF’s NAV at the end of the day on which the transaction was initiated.

Figure 3.3

Creation of ETF Shares

 

Figure 3.3

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Note: The creation basket represents a specific list of securities, cash, and/or other assets.

The AP can either keep the ETF shares that make up the creation unit or sell all or part of them to its clients or to other investors on a stock exchange, in a “dark pool” (private exchange), or in other trading venues. Any purchases and sales of existing ETF shares among investors, including APs, are referred to as secondary market trading or activity.

Redemption

The redemption process in the primary market is simply the reverse of the creation process. A creation unit is redeemed when an AP acquires the number of ETF shares specified in the ETF’s creation unit and returns the creation unit to the ETF. In return, the AP receives the daily redemption basket of securities, cash, and/or other assets. The total value of the redemption basket is equivalent to the value of the creation unit based on the ETF’s NAV at the end of the day on which the transaction was initiated.

What Is an AP? 

An authorized participant (AP) is typically a large financial institution that enters into a legal contract with an ETF distributor to create and redeem shares of the fund. In addition, APs are U.S.-registered, self-clearing broker-dealers that can process all required trade submission, clearance, and settlement transactions on their own account, as well as full participating members of the National Securities Clearing Corporation and the Depository Trust Company.

APs play a key role in the primary market for ETF shares because they are the only investors allowed to interact directly with the fund. APs do not receive compensation from an ETF or its sponsor and have no legal obligation to create or redeem the ETF’s shares. APs typically derive their compensation from acting as dealers in ETF shares and create and redeem shares in the primary market when doing so is a more effective way of managing their firms’ aggregate exposure than trading in the secondary market. Some APs are clearing brokers (rather than dealers) and receive payment for processing creations and redemptions as an agent for a wide array of market participants such as registered investment advisers and various liquidity providers, including market makers, hedge funds, and proprietary trading firms.

Some APs also play another role in the ETF ecosystem by acting as registered market makers in ETF shares that trade on an exchange. Secondary market trading of ETFs, however, does not rely solely on these APs. In fact, a host of other entities provide liquidity—two-sided (buy and sell) quotes—in ETF shares other than APs. These other entities also help facilitate trading of ETF shares in the secondary market. Domestic equity ETFs have the most liquidity providers (Figure 3.4). But other types of ETFs—such as emerging market equity, domestic high-yield bond, and emerging market bond—also have multiple liquidity providers in the secondary market.

Figure 3.4

There Are Many ETF Liquidity Providers in the Secondary Market

December 2014

Figure 3.4

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1For the purposes of the survey, liquidity provider was defined as an entity that regularly provides two-sided quotes in an ETF’s shares.
2A registered market maker is registered with a particular exchange to provide two-sided markets in an ETF’s shares.
Source: Investment Company Institute, The Role and Activities of Authorized Participants of Exchange-Traded Funds

How ETFs Trade 

The price of an ETF share on a stock exchange is influenced by the forces of supply and demand. Though imbalances in supply and demand can cause the price of an ETF share to deviate from its underlying value, 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 APs to create or redeem ETF shares at the 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 an estimate of an ETF’s underlying value. This calculation, often called the intraday indicative value (IIV), is based on the prior day’s portfolio holdings and is disseminated at regular intervals during the trading day (typically every 15 seconds). Some market participants 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 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 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 share price and its underlying value occurs, APs (for their own behalf or on behalf of other market participants) may create or redeem creation units in the primary market in an effort to capture a profit. For example, when an ETF is trading at a discount, market participants may find it profitable to buy the ETF shares and sell short the underlying securities. At the end of the day, APs return ETF shares to the fund in exchange for the ETF’s redemption basket, which is used to cover the short positions in the underlying securities. When an ETF is trading at a premium, market 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 APs (for their own behalf or on behalf of other market participants) will deliver the creation basket to the ETF in exchange for ETF shares that are used to cover the ETF short sales. These market participant actions, commonly described as arbitrage opportunities, help keep the market-determined price of an ETF’s shares close to its underlying value.

Secondary Market Trading in ETF Shares 

ETF investors trading in the secondary market (e.g., on an exchange) do not interact with the ETF directly and do not create transactions in the underlying securities, because only the ETF shares are changing hands. Although many large institutional investors can access ETFs in both the primary and secondary markets, most retail investors only access ETFs in the secondary market. Most ETF investors trading in the secondary market generally are not motivated by arbitrage (i.e., the desire to make a profit from the difference between the market price of the ETF and its underlying value). Across all ETFs, investors make greater use of the secondary market (trading ETF shares) than the primary market (creations and redemptions of ETF shares through an AP). On average, 89 percent of the total daily activity in ETFs occurs on the secondary market (Figure 3.5). Even for ETFs with narrower investment objectives—such as emerging market equity, domestic high-yield bond, and emerging market bond—the bulk of the trading occurs on the secondary market (95 percent, 79 percent, and 74 percent, respectively). On average, secondary market trading is a smaller proportion (77 percent) of total trading for bond ETFs than for equity ETFs (90 percent). Because bond ETFs are a growing segment of the industry, many small bond ETFs tend to have less-established secondary markets. As they increase their assets under management, the secondary market for bond ETFs is likely to deepen naturally.

Figure 3.5

Most ETF Activity Occurs on the Secondary Market

Percentage of secondary market activity1 relative to total activity;2 daily, January 3, 2013–December 31, 2015

Figure 5.5

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1Secondary market activity is measured as average daily dollar volume of ETF shares traded in each category over the 756 daily observations in the sample.
2Total activity is measured as the sum of primary market and secondary market activity. Primary market activity is computed as daily creations or redemptions for each ETF, which are estimated by multiplying the daily change in shares outstanding by the daily NAV from Bloomberg. Aggregate daily creations and redemptions are computed by adding creations and the absolute value of redemptions across all ETFs in each investment objective each day. Average daily creations and redemptions are the average of the aggregate daily creations and redemptions over the 756 daily observations in the sample.
Sources: Investment Company Institute and Bloomberg

ETF secondary market trading also can act as a source of liquidity to the broader financial markets. In December 2015, the high-yield bond market experienced periods of stress, as market participants reassessed the risks of this sector and sent prices for many such bonds tumbling. During that stressed time, high-yield bond ETFs added substantial liquidity to the underlying high-yield bond market (Figure 3.6). At the height of the turmoil, trading in both high-yield bonds and high-yield bond ETFs surged—the average weekly value traded of high-yield bond ETFs was $15.7 billion, while average weekly transaction volume in high-yield bonds was $62.3 billion. Secondary market trading of high-yield bond ETFs added 25 percent ($15.7 billion/$62.3 billion) to weekly liquidity in the high-yield market during this tumultuous period. In comparison, in the other weeks of the year, secondary market trading of high-yield bond ETFs and transaction volume in high-yield bonds averaged $5.4 billion and $53.0 billion, respectively—meaning that high-yield bond ETFs generally added 10 percent ($5.4 billion/$53.0 billion) to liquidity in the high-yield bond market. As investors sought to shed or gain exposure, depending on their risk appetites and expectations of future returns, high-yield bond ETFs provided them with an efficient means of transferring risk while limiting the impact on the underlying high-yield bond market.

Figure 3.6

High-Yield Bond ETFs Added Liquidity to the High-Yield Bond Market

Secondary market trading; billions of dollars; weekly, 2015

Figure 3.6

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Note: Data exclude high-yield bond ETFs designated as floating rate.
Sources: Investment Company Institute, Bloomberg, and FINRA TRACE

Demand for ETFs 

In the past decade, demand for ETFs has increased as institutional investors have found ETFs to be a convenient vehicle for participating in, or hedging against, broad movements in the stock market. Increased awareness of these investment vehicles by retail investors and their financial advisers also has influenced demand for ETFs. Assets in ETFs accounted for about 12 percent of total net assets managed by investment companies at year-end 2015. Net issuance of ETF shares was at a near-record pace of $231 billion in 2015 (Figure 3.7).

Figure 3.7

Net Issuance of ETF Shares

Billions of dollars, 2006–2015

Figure 3.7

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1The funds in this category are not registered under the Investment Company Act of 1940 and invest primarily in commodities, currencies, and futures.
2The funds in this category are registered under the Investment Company Act of 1940.
Note: Data for ETFs that invest primarily in other ETFs are excluded from the totals. Components may not add to the total because of rounding.

Overall net issuance of ETF shares remained strong in 2015, despite lackluster performance in domestic and international stock and bond markets. Global and international equity ETFs saw net issuance of $110 billion in 2015, up substantially from $47 billion in 2014 (Figure 3.8). Net issuance of bond and hybrid ETFs remained steady at $56 billion in 2015 compared with $53 billion in 2014. Broad-based domestic equity ETFs had positive net issuance ($50 billion) in 2015, though at half their pace in 2014. Declines in energy prices likely tempered demand for domestic sector equity ETFs, which had $13 billion in net share issuance, down from $41 billion in 2014. Commodity ETFs had net issuance of $2 billion in 2015, compared with
net redemptions of $1 billion in 2014.

Figure 3.8

Net Issuance of ETF Shares by Investment Classification

Billions of dollars, 2013–2015

Figure 3.8

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1This category includes funds both registered and not registered under the Investment Company Act of 1940.
2Bond ETFs represented 99 percent of flows in the bond and hybrid category in 2015.
3This category includes funds—both registered and not registered under the Investment Company Act of 1940—that invest primarily in commodities, currencies, and futures.
Note: Data for ETFs that invest primarily in other ETFs are excluded from the totals.

ETFs have been available for more than 20 years, and in that time, large-cap domestic equity ETFs have accounted for the largest proportion of all ETF assets—27 percent, or $561 billion, at year-end 2015 (Figure 3.9). Strong investor demand over the past seven years has made global/international equity ETFs the second-largest category with 23 percent ($475 billion) of all ETF assets. Bond and hybrid ETFs accounted for 16 percent ($344 billion) of all ETF assets.
 

Figure 3.9

Total Net Assets of ETFs Were Concentrated in Large-Cap Domestic Stocks

Billions of dollars, year-end 2015

Figure 3.9

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1This category includes international, regional, and single country ETFs.
2Bond ETFs represented 99 percent of the assets in the bond and hybrid category in 2015.
3This category includes funds—both registered and not registered under the Investment Company Act of 1940—that invest primarily in commodities, currencies, and futures.
Note: Data for ETFs that invest primarily in other ETFs are excluded from the totals.

Increased investor demand for ETFs led to a rapid increase in the number of ETFs created by fund sponsors in the past decade (Figure 3.10). In the past decade, 1,817 ETFs were created—the peak years came in 2007, with 269 new funds, and 2015, with 258 new funds. Few ETFs had been liquidated until 2008 when market pressures appeared and sponsors began liquidating ETFs that had failed to gather sufficient assets. Liquidations occurred primarily among ETFs tracking virtually identical indexes, those focusing on specialty or niche indexes, or those using alternative weighting methodologies. In 2012, the number of ETF liquidations jumped to 81 as two sponsors exited the index-based ETF market. In 2015, ETF liquidations rose to 75, as several sponsors eliminated some small domestic equity and bond ETFs from their lineups.
 

Figure 3.10

Number of ETFs Entering and Leaving the Industry

2006–2015

Figure 3.10

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Note: ETF data include ETFs not registered under the Investment Company Act of 1940 but exclude ETFs that invest primarily in other ETFs.

Characteristics of ETF-Owning Households 

An estimated 6.2 million, or 5 percent of, U.S. households held ETFs in mid-2015. Of households that owned mutual funds, an estimated 10 percent also owned ETFs. ETF-owning households tended to include affluent investors who owned a range of equity and fixed-income investments. In mid-2015, 93 percent of ETF-owning households also owned equity mutual funds, individual stocks, or variable annuities (Figure 3.11). Sixty-two percent of households that owned ETFs also held bond mutual funds, bonds, or fixed annuities. In addition, 42 percent of ETF owning households owned investment real estate.

Figure 3.11

ETF-Owning Households Held a Broad Range of Investments

Percentage of ETF-owning households holding each type of investment, mid-2015

   
Equity mutual funds, individual stocks, or variable annuities (total) 93
Bond mutual funds, individual bonds, or fixed annuities (total) 62
Mutual funds (total) 90
    Equity  88
    Bond  50
    Hybrid  45
    Money market  58
Individual stocks 71
Individual bonds 24
Fixed or variable annuities 29
Investment real estate  42

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Note: Multiple responses are included.

Some characteristics of retail ETF owners are similar to those of households that own mutual funds and those that own stocks directly. For instance, households that owned ETFs—like households owning mutual funds and those owning individual stocks—tended to have household incomes above the national median and to own at least one defined contribution (DC) retirement plan account (Figure 3.12). ETF-owning households, however, also exhibit some characteristics that distinguish them from other households. For example, ETF-owning households tended to have higher education levels and greater household financial assets; they also were more likely to own an individual retirement account (IRA) than households that own mutual funds and those that own individual stocks.

Figure 3.12

Characteristics of ETF-Owning Households

Mid-2015

  All U.S.
households
Households
owning
ETFs
Households
owning
mutual
funds
Households
owning
individual
stocks
Median
Age of head of household1 51 51 51 52
Household income2 $50,500 $110,000 $87,500 $100,000
Household financial assets3 $75,000 $375,000 $200,000 $300,000
Percentage of households
    Household primary or co-decisionmaker for saving and investing
        Married or living with a partner 58 75 71 69
        Widowed 9 5 6 8
        Four-year college degree or more 32 65 51 54
        Employed (full- or part-time) 59 71 71 69
        Retired from lifetime occupation 28 27 26 29
Household owns
        IRA(s) 32 75 61 62
        DC retirement plan account(s) 46 74 84 69

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1 Age is based on the sole or co-decisionmaker for household saving and investing.
2 Total reported is household income before taxes in 2014.
3 Household financial assets include assets in employer-sponsored retirement plans but exclude the household’s primary residence.

ETF-owning households also exhibit more willingness to take investment risk (Figure 3.13). Fifty-three percent of ETF-owning households were willing to take substantial or above-average investment risk for substantial or above-average gain in 2015, compared with 21 percent of all U.S. households and 31 percent of mutual fund–owning households. This result may be explained by the predominance of equity ETFs, which make up 81 percent of ETF total net assets (Figure 3.9). Investors who are more willing to take investment risk may be more likely to invest in equities.

Figure 3.13

ETF-Owning Households Are Willing to Take More Investment Risk

Percentage of all U.S. households, mutual fund–owning households, and ETF-owning households, mid-2015

Figure 3.13

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