What Is an ETF?

An exchange-traded fund (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 nearly 25 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 had 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 actively managed mutual fund, creates a unique mix of investments to meet a particular investment objective and policy. At year-end 2016, 148 actively managed ETFs—with nearly $29 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 US 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.

US ETF Assets

The US ETF market—with 1,716 funds and $2.5 trillion in assets under management at year-end 2016—remained the largest in the world, accounting for 73 percent of the $3.5 trillion in ETF assets worldwide (Figure 3.1 and Figure 3.2).

The vast majority of assets in US ETFs are in funds registered with and regulated by the SEC under the Investment Company Act of 1940 (Figure 3.2). At year-end 2016, about 2 percent of assets were held in non–1940 Act ETFs, which are not registered with or regulated by the SEC under the Investment Company Act of 1940; 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 2016

Figure 3.1

 

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Note: Components do not add to 100 percent because of rounding.
Sources: Investment Company Institute and ETFGI


Figure 3.2

Total Net Assets and Number of ETFs

Billions of dollars; year-end, 2007–2016

Figure 3.2

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1 The funds in this category are not registered under the Investment Company Act of 1940 and invest primarily in commodities, currencies, and futures.
2 The 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. 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.

Index-based ETFs track their target index in various ways. 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 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 and 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 and 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 from 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 (see here), 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 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 and any cash adjustment 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 US-registered, self-clearing broker-dealers that can process all required trade submission, clearance, and settlement transactions on their own account; they are also 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

The Secondary Market Has Many ETF Liquidity Providers

December 2014

Figure 3.4

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1 For the purposes of the survey, liquidity provider was defined as an entity that regularly provides two-sided quotes in an ETF’s shares.
2 A 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 or sell the underlying securities or do both. 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 or buy the underlying securities or do both. These actions should bring the price of the ETF and the market value of its underlying securities closer together by reducing the ETF share price or raising the price of the underlying securities or both.

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 market 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 actions by market participants, commonly described as arbitrage, 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 them in the secondary market. Most ETF investors trading in the secondary market generally are not motivated by arbitrage.

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 73 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.

Figure 3.5

Most ETF Activity Occurs on the Secondary Market

Percentage of secondary market activity1 relative to total activity;2 daily, January 2, 2014–December 31, 2016

Figure 5.5

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1 Secondary market activity is measured as average daily dollar volume of ETF shares traded in each category over the 756 daily observations in the sample.
2 Total 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. Over the second half of 2016, long-term interest rates in the United States rose—slowly creeping up from July through October and then jumping after the presidential election. On July 8, 2016, the yield on the 10-year constant maturity Treasury bond hit a recent low of 1.37 percent (Figure 3.6). From July 8 to October 31, the 10-year yield rose to 1.84 percent. By the end of November, it had jumped further, to 2.37 percent. All told, the yield on the 10‑year Treasury rose 108 basis points from July 8 to December 30. When bond yields increase, prices on existing bonds—such as those that funds hold in their portfolios—and bond ETFs fall.

Figure 3.6

Secondary Market Trading of Taxable Bond ETFs Increased When Interest Rates Rose in the Second Half of 2016

December 31, 2015–December 30, 2016*

Figure 3.6

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* Data for 10-year constant maturity Treasury yield are daily. Data for taxable bond ETFs’ secondary market dollar volume and net share issuance are week-ended Wednesday. Sources: Investment Company Institute, Federal Reserve Board, and Bloomberg

Despite declining prices for bond ETFs since July 8, 2016, sellers of taxable bond ETFs were able to find willing buyers in the secondary market. Weekly dollar volume of taxable bond ETFs traded on the secondary markets (green bars, Figure 3.6) increased in the second half of 2016 (average of $32.0 billion per week) compared with the first half of the year (average of $30.1 billion per week). In addition, there was demand for new shares of taxable bond ETFs while interest rates were rising in the latter half of 2016—net share issuance was positive in 21 out of 25 weeks since July 8, 2016 (blue bars, Figure 3.6). Also noteworthy are the relative magnitudes of secondary market trading and net share issuance in taxable bond ETFs—secondary market trading activity is many multiples higher than primary market activity for these ETFs. As investors seek to shed or gain exposure, depending on their risk appetites and expectations of future returns, bond ETFs provide them with an efficient means of transferring risk amongst themselves while limiting the impact on the underlying bond market.

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 13 percent of total net assets managed by investment companies at year-end 2016. For 2016 as a whole, net issuance of ETF shares (which includes reinvested dividends) hit a record $284 billion (Figure 3.7).

Figure 3.7

Net Issuance of ETF Shares

Billions of dollars; annual, 2007–2016

Figure 3.7

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

In 2016, net share issuance of domestic equity ETFs outpaced that of global and international equity ETFs, a reversal from 2015. Demand for broad-based domestic equity ETFs surged in 2016, with $148 billion in net new shares issued, up from $50 billion in 2015 (Figure 3.8). In contrast, demand for global and international equity ETFs waned with net share issuance falling from $110 billion in 2015 to $20 billion in 2016. This shift in demand in 2016 likely reflected, in part, the better total return performance of domestic stocks* (11 percent) versus international stocks (5 percent). Demand for bond and hybrid ETFs strengthened further in 2016 with net new share issuance totaling $85 billion, up from $56 billion in 2015. As energy and gold prices moved off their year-end 2015 lows, net share issuance of domestic sector equity ETFs and commodity ETFs picked up somewhat in 2016.

* As measured by the Wilshire 5000 Total Return Index (float-adjusted).
As measured by the MSCI All Country World Daily ex-US Gross Total Return Index.

Figure 3.8

Net Issuance of ETF Shares by Investment Classification

Billions of dollars; annual, 2014–2016

Figure 3.8

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1 Bond ETFs represented 99 percent of net issuance in the bond and hybrid category in 2016.
2 This 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 net issuance include reinvested dividends. Data for ETFs that invest primarily in other ETFs are excluded from the totals.

ETFs have been available for nearly 25 years, and in that time, large-cap domestic equity ETFs have accounted for the largest proportion of all ETF assets. At year-end 2016, large-cap domestic equity ETFs amounted to $687 billion—or 27 percent—of all ETF assets (Figure 3.9). The second-largest category, with 20 percent ($503 billion) of all ETF assets, was global and international equity ETFs. Fueled by strong investor demand over the past few years, bond and hybrid ETFs accounted for 17 percent, or $432 billion, of all ETF assets at year-end 2016.

Figure 3.9

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

Billions of dollars, year-end 2016

Figure 3.9

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1 This category includes international, regional, and single country ETFs, but excludes emerging market ETFs.
2 Bond ETFs represented 99 percent of the assets in the bond and hybrid category in 2016.
3 This 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 has led to a rapid increase in the number of ETFs created by fund sponsors, with 1,877 new ETFs offered to investors in the past decade (Figure 3.10). In 2015 and 2016, international and global equity ETFs accounted for 42 percent of newly offered ETFs. Domestic equity ETFs—many of which were based on factors (commonly referred to as smart beta ETFs) accounted for 44 percent of new ETFs in 2015 and 2016. 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. In 2012, the number of liquidations jumped to 81 as two sponsors exited the index-based ETF market. Since 2013, the number of ETF liquidations has risen steadily—a natural result of a maturing industry. In 2016, ETF liquidations rose to 97, as sponsors eliminated some small international equity and commodity ETFs from their lineups.

Figure 3.10

Number of ETFs Entering and Exiting the Industry

2007–2016

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 5.9 million, or about 5 percent of, US households held ETFs in mid-2016. 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-2016, 96 percent of ETF-owning households also owned equity mutual funds, individual stocks, or variable annuities (Figure 3.11). Sixty-three percent of households that owned ETFs also held bond mutual funds, individual bonds, or fixed annuities. In addition, 41 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-2016

  
Equity mutual funds, individual stocks, or variable annuities (total) 96
Bond mutual funds, individual bonds, or fixed annuities (total) 63
Mutual funds (total) 91
    Equity 85
    Bond  49
    Hybrid  45
    Money market  60
Individual stocks 77
Individual bonds 18
Fixed or variable annuities 36
Investment real estate 41

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Note: Multiple responses are included.

Some characteristics of ETF-owning households 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 were also more likely to own individual retirement accounts (IRAs) than households that own mutual funds and those that own individual stocks.

Figure 3.12

Characteristics of ETF-Owning Households

Mid-2016

 All US
households
Households
owning
ETFs
Households
owning
mutual
funds
Households
owning
individual
stocks
Median
Age of head of household1 51 51 51 53
Household income2 $55,000 $120,000 $94,300 $100,000
Household financial assets3 $85,000 $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 74 73 73
        Widowed 9 5 6 7
        College or postgraduate degree 33 67 50 55
        Employed (full- or part-time) 62 78 76 74
        Retired from lifetime occupation 28 22 24 26
   Household owns
        IRA(s) 34 77 63 62
        DC retirement plan account(s) 47 78 85 74

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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 2015.
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-two percent of ETF-owning households were willing to take substantial or above-average investment risk for substantial or above-average gain in 2016, compared with 21 percent of all US households and 33 percent of mutual fund­–owning households. This result may be explained by the predominance of equity ETFs, which make up 80 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 US households, mutual fund–owning households, and ETF-owning households; mid-2016

Figure 3.13

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