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

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, more than $1.2 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 nearly $1.7 trillion in assets, the U.S. ETF industry remained the largest in the world at year-end 2013. While 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 an investment company whose shares are traded intraday on stock exchanges at market-determined prices. 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 (open-end funds) or unit investment trusts, but other structures also exist—primarily for ETFs investing in commodities, currencies, and futures.

ETFs have been available as an investment product for a little more than 20 years in the United States. 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 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.

U.S. ETF Assets

The U.S. ETF market—with 1,294 funds and nearly $1.7 trillion in assets under management at year-end 2013—remained the largest in the world, accounting for 72 percent of the $2.3 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 2013, about 4 percent of assets were held in ETFs that 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 2013

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, 2002–2013

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.
Sources: Investment Company Institute and Federal Reserve Board

Creation of an ETF

An ETF originates with a sponsor, the 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 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 the case of an actively managed ETF, the sponsor also determines the investment objective of the fund and may trade securities at its discretion, much like an actively managed mutual fund.

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 broker-dealer—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 also may 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.

Figure 3.3

Creation of an ETF

Figure 3.3

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The authorized participant 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 exchanges where investors can purchase them as they would shares of a publicly traded company.

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 Funds

A 1940 Act 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 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. 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 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 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 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.

How ETFs Trade

The 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 the NAV at the end of each trading day.

The transparency of an ETF’s holdings 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 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, and also may purchase or sell creation units directly with the ETF. For example, 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 which they use to cover their short positions. 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. 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 ETFs

In the past seven years, demand for ETFs has increased as institutional investors have found ETFs 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 10 percent of total net assets managed by investment companies at year-end 2013. Net issuance of ETF shares in 2013 amounted to $180 billion, just shy of the record $185 billion in issuance in 2012 (Figure 3.4).

Figure 3.4

Net Issuance of ETF Shares

Billions of dollars, 2002–2013

Figure 3.4

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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.

In 2013, changes in investor demand for specific types of ETFs were likely related to relative performance across the stock, bond, and commodity markets. Considerable gains in major U.S. stock indexes spurred demand for domestic equity ETFs, while rising long-term interest rates in the United States and tumbling commodity prices dampened demand for bond and commodity ETFs (Figure 3.5). Net issuance of broad-based domestic equity ETFs increased to $99 billion in 2013 from $58 billion in 2012 and domestic sector equity ETFs experienced net issuance of $34 billion in 2013, up from $14 billion in 2012. Demand for global and international equity ETFs remained strong in 2013 with $63 billion in net issuance, up from $52 billion in 2012. In contrast, bond and hybrid ETFs saw net issuance of $13 billion in 2013, down from $53 billion in 2012, and commodity ETFs had net redemptions of $30 billion in 2013 compared with net issuance of $9 billion in 2012.

Figure 3.5

Net Issuance of ETF Shares by Investment Classification

Billions of dollars, 2011–2013

Figure 3.5

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1 Bond ETFs represented 93.63 percent of flows in the bond and hybrid category in 2013.
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 ETFs that invest primarily in other ETFs are excluded from the totals.

ETFs have been available for the past 20 years, and in that time, large-cap domestic equity ETFs have accounted for the largest proportion of all ETF assets—26 percent, or $444 billion, at year-end 2013 (Figure 3.6). Solid performance in international stock markets and strong investor demand over the past five years has propelled global/international equity ETFs to the second-largest category with 24 percent ($399 billion) of all ETF assets. Despite negative performance and slowing demand in 2013, bond and hybrid ETFs accounted for 15 percent ($247 billion) of all ETF assets.

Figure 3.6

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

Billions of dollars, year-end 2013

Figure 3.6

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1 This category includes international, regional, and single country ETFs.
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.
3 Bond ETFs represented 99.41 percent of the assets in the bond and hybrid category in 2013.
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 3.7). From year-end 2003 to year-end 2013, 1,469 ETFs were created—the peak years came in 2007, with 270 new funds, and 2011, with 226 new funds. In 2013, 143 ETFs were created. 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 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 liquidations jumped to 81 as two sponsors exited the index-based ETF market. In 2013, 46 ETFs were liquidated. On net, there were 97 more ETFs at year-end 2013 compared with year-end 2012, bringing the total number of ETFs to 1,294.

Figure 3.7

Number of ETFs

2002–2013

  Created Liquidated Total at year-end
2002 14 3 113
2003 10 4 119
2004 35 2 152
2005 52 0 204
2006 156 1 359
2007 270 0 629
2008 149 50 728
2009 120 49 797*
2010 177 51 923
2011 226 15 1,134
2012 141 81 1,194
2013 143 46 1,294*

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* The difference between the number of ETFs created and liquidated may not equal the difference between the total number of ETFs at year-end because of conversions. In 2009, two ETFs converted from holding securities directly to investing primarily in other ETFs. In 2013, three ETFs converted from investing primarily in other ETFs to holding securities directly. 
Note: ETF data include ETFs not registered under the Investment Company Act of 1940 but exclude ETFs that invest primarily in other ETFs.

As demand for ETFs has grown, ETF sponsors have offered not only a greater number of funds, but a greater variety, including ETFs investing in particular market sectors, industries, or commodities (either directly or through the futures market). At year-end 2013, there were 311 commodity and sector ETFs, with commodity ETFs representing the largest category at 24 percent (Figure 3.8). The second-largest category, natural resource ETFs, which hold securities of publicly traded companies involved in mining or production of natural resources, accounted for 16 percent of the total number of sector and commodity ETFs. Commodity and sector ETFs altogether held $267 billion in assets (Figure 3.9). Although commodity ETFs remained the largest category in this group with 24 percent of net assets at year-end 2013, their share was down substantially from 47 percent at year-end 2012. Net redemptions and declining gold and silver prices were the primary drivers behind the drop in commodity ETF assets in 2013.

ETF sponsors continued building on recent innovations by launching additional actively managed ETFs. During 2013, 19 actively managed ETFs were launched, bringing the total number of actively managed ETFs to 61, with more than $14 billion in total net assets at year-end.

Figure 3.8

Number of Commodity and Sector ETFs

Percent, year-end 2013

Figure 3.8

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* 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. Components do not add to 100 percent because of rounding.

Figure 3.9

Total Net Assets of Commodity and Sector ETFs

Percent, year-end 2013

Figure 3.9

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* 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. Components do not add to 100 percent because of rounding.

Characteristics of ETF-Owning Households

An estimated 5.7 million, or 5 percent of, U.S. households held ETFs in 2013. Of households that owned mutual funds, an estimated 10 percent also owned ETFs. ETF-owning households tended to include affluent, experienced investors who owned a range of equity and fixed-income investments. In 2013, 97 percent of ETF-owning households also owned stocks, either directly or through equity mutual funds or variable annuities (Figure 3.10). Seventy-two percent of households that owned ETFs also held bond mutual funds, bonds, or fixed annuities. In addition, 48 percent of ETF-owning households owned investment real estate.

Figure 3.10

ETF-Owning Households Held a Broad Range of Investments

Percentage of ETF-owning households holding each type of investment, May 2013

Equity mutual funds, equities, or variable annuities (total) 97
Bond mutual funds, bonds, or fixed annuities (total) 72
Mutual funds (total) 96
   Equity mutual funds 92
   Bond mutual funds 60
   Hybrid mutual funds 35
   Money market funds 65
Individual equities 74
Bonds 21
Fixed or variable annuities 33
Investment real estate 48

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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 equities—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 other households. For example, ETF-owning households tended to have higher incomes, greater household financial assets, and were more likely to own an individual retirement account (IRA) than households that own mutual funds and those that own individual equities.

Figure 3.11

Characteristics of ETF-Owning Households

May 2013

  All U.S.
households
Households
owning ETFs
Households
owning individual
equities
Households
owning individual
equities
Median
Age of head of household1 51 49 52 52
Household income2 $50,000 $96,800 $80,000 $90,000
Household financial assets3 $75,000 $450,000 $200,000 $300,000
Percentage of households
Household primary or co-decisionmaker for saving and investing
Married or living with a partner 64 80 76 75
Widowed 11 6 7 8
Four-year college degree or more 33 60 47 52
Employed (full- or part-time) 57 71 69 67
Retired from lifetime occupation 30 32 28 32
Household owns
IRA(s) 38 78 63 65
DC retirement plan account(s) 53 77 85 76

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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 2012.
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 3.12). Forty-five percent of ETF-owning households are willing to take substantial or above-average investment risk for substantial or above-average gain compared with 21 percent of all U.S. households and 30 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. Investors who are more willing to take investment risk may be more likely to invest in equities.

Figure 3.12

ETF-Owning Households Are Willing to Take More Investment Risk

Percentage of all U.S. households, mutual fund–owning households, and ETF-owning households, May 2013

Figure 3.12

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