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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.

Investors seeking to gain or shed exposure to broad market indexes, particular sectors or geographical regions, or specific rules-based investment strategies find that ETFs are a convenient, cost-effective tool to achieve these objectives. 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 $1.4 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 $2.0 trillion in assets, the U.S. ETF industry remained the largest in the world at year-end 2014. 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 a pooled investment vehicle with shares that can be bought and sold 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 (open-end funds) or unit investment trusts, but some ETFs—primarily those investing in commodities, currencies, and futures—have different structures.

ETFs have been available as an investment product for 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 1,411 funds and nearly $2.0 trillion in assets under management at year-end 2014—remained the largest in the world, accounting for 73 percent of the $2.7 trillion in ETF assets worldwide (Figure 3.1 and Figure 3.2).

Figure 3.1

The United States Has the Largest ETF Market

Percentage of total net assets, year-end 2014

Figure 3.1

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Sources: Investment Company Institute and ETFGI

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 2014, about 3 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 3.2

Total Net Assets and Number of ETFs

Billions of dollars; year-end, 2003–2014

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. 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

Each business day, ETFs are required to provide the makeup of 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

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). When ETF shares are created or redeemed, this is categorized as primary market activity. ETF shares are created when an “authorized participant”—typically a large institutional investor, such as a market maker or broker-dealer that has entered into a legal contract with an ETF—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 authorized participant when the specified creation basket is transferred to the ETF. The ETF may permit or require an authorized participant 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 authorized participant 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 net asset value (NAV) at the end of the day on which the transaction was initiated.

The authorized participant 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. These sales by the authorized participant, along with any subsequent purchases and sales of these existing ETF shares among investors, are referred to as secondary market activity.

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.

Redemption

The redemption process in the primary market is simply the reverse. A creation unit is redeemed when an authorized participant acquires the number of ETF shares specified in the ETF’s creation unit and returns the creation unit to the ETF. In return, the authorized participant 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.

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 authorized participants 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 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 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, 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, 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 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.

Primary Market Activity and Secondary Market Trading in ETF Shares

Investors can trade ETFs in the primary market and the secondary market. In the primary market, authorized participants create or redeem ETF shares, whereas in the secondary market, investors purchase or sell securities on stock exchanges, in “dark pools” (private exchanges), and in other trading venues. Many large institutional investors can access ETFs in both the primary and secondary markets, while most retail investors access ETFs in the secondary market. Investors involved in many of these ETF secondary market trades 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). These investors do not interact with the ETF directly and do not create transactions in the underlying securities, because only the ETF shares are trading hands.

Across all ETFs, investors use the secondary market more than the primary market when trading ETFs (Figure 3.4). On average, 90 percent of the total daily activity in ETFs occurs on the secondary market. Even for ETFs with narrower investment objectives—such as emerging markets equity, domestic high-yield bond, and emerging markets bond—the bulk of the trading occurs on the secondary market (94 percent, 83 percent, and 78 percent, respectively). On average, secondary market trading is a smaller proportion (81 percent) of total trading for bond ETFs than for equity ETFs (91 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 3.4

Most ETF Activity Occurs on the Secondary Market

Percentage of secondary market activity1 relative to total activity;2 daily, January 3, 2013–June 30, 2014

Figure 3.4

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1 Measured as average daily dollar volume of ETF shares traded in each category over the 375 daily observations in the sample.
2 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 375 daily observations in the sample.
3 All is the weighted average of equity, bond, hybrid, and commodity ETF market activity.
Sources: Investment Company Institute and Bloomberg

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 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 by the fund company. 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 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.

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 11 percent of total net assets managed by investment companies at year-end 2014. Net issuance of ETF shares reached a record $241 billion (Figure 3.5).

Figure 3.5

Net Issuance of ETF Shares

Billions of dollars, 2003–2014

Figure 5.5

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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 2014, changes in investor demand for specific types of ETFs were likely related to relative performance across the stock, bond, and commodity markets. Continued gains in major U.S. stock indexes and declining long-term interest rates in the United States spurred demand for domestic equity and bond ETFs (Figure 3.6). Net issuance of broad-based domestic equity ETFs increased to $102 billion in 2014 from $99 billion in 2013 and domestic sector equity ETFs experienced net issuance of $41 billion in 2014, up from $34 billion in 2013. In contrast, demand for global and international equity ETFs slowed in 2014 with $47 billion in net issuance, down from $63 billion in 2013. Bond and hybrid ETFs saw net issuance of $53 billion in 2014, up from $13 billion in 2013, and commodity ETFs had net redemptions of $1 billion in 2014, compared with net redemptions of $30 billion in 2013.

Figure 3.6

Net Issuance of ETF Shares by Investment Classification

Billions of dollars, 2012–2014

Figure 3.6

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1 Bond ETFs represented 97 percent of flows in the bond and hybrid category in 2014.
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—28 percent, or $556 billion, at year-end 2014 (Figure 3.7). Solid performance in international stock markets and strong investor demand over the past six years has made global/international equity ETFs the second-largest category with 21 percent ($415 billion) of all ETF assets. Bond and hybrid ETFs accounted for 15 percent ($299 billion) of all ETF assets.

Figure 3.7

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

Billions of dollars, year-end 2014

Figure 3.7

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1 This category includes international, regional, and single country ETFs.
2 Bond ETFs represented 99 percent of the assets in the bond and hybrid category in 2014.
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 led to a rapid increase in the number of ETFs created by fund sponsors in the past decade (Figure 3.8). From year-end 2003 to year-end 2014, 1,645 ETFs were created—the peak years came in 2007, with 270 new funds, and 2011, with 226 new funds. In 2014, 176 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 2014, 59 ETFs were liquidated. On net, there were 117 more ETFs at year-end 2014 than at year-end 2013, bringing the total number of ETFs to 1,411.

Figure 3.8

Number of ETFs

2003–2014

Year Created Liquidated/
Merged
Total at
year-end
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*
2014 176 59 1,411

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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 2014, there were 318 commodity and domestic sector equity ETFs, with commodity ETFs representing the largest category at 26 percent (Figure 3.9). The second-largest category, natural resource ETFs, which hold securities of publicly traded companies involved in mining or production of natural resources, accounted for 17 percent of the total number of sector and commodity ETFs. Commodity and domestic sector equity ETFs altogether held $324 billion in assets. Although commodity ETFs remained the largest category in this group with 18 percent of net assets at year-end 2014, their share was down from 24 percent at year-end 2013. Tepid demand for commodity ETFs and weakness in gold and silver prices were the primary drivers behind the drop in commodity ETF assets in 2014.

ETF sponsors continued building on recent innovations by launching additional actively managed ETFs. During 2014, 53 actively managed ETFs were launched, bringing the total number of actively managed ETFs to 111, with nearly $17 billion in assets at year-end.

Figure 3.9

Types of Commodity and Domestic Sector Equity ETFs

Percent, year-end 2014

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 may not add to 100 percent because of rounding.

Characteristics of ETF-Owning Households

An estimated 5.2 million, or 4 percent of, U.S. households held ETFs in mid-2014. Of households that owned mutual funds, an estimated 9 percent also owned ETFs. ETF-owning households tended to include affluent, experienced investors who owned a range of equity and fixed-income investments. In mid-2014, 93 percent of ETF-owning households also owned equity mutual funds, individual stocks, or variable annuities (Figure 3.10). Sixty-five percent of households that owned ETFs also held bond mutual funds, bonds, or fixed annuities. In addition, 41 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, mid-2014

   
Equity mutual funds, individual equities, or variable annuities (total) 93
Bond mutual funds, individual bonds, or fixed annuities (total) 65
Mutual funds (total) 89
  Equity  85
  Bond  53
  Hybrid  46
  Money market  60
Individual equities 73
Individual bonds 23
Fixed or variable annuities 28
Investment real estate  41

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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 and greater household financial assets; they were also 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

Mid-2014

  All U.S. households Households owning ETFs Households owning mutual funds Households owning individual equities
Median        
Age of head of household1 51 51 51 53
Household income2 $50,000 $110,000 $85,000 $90,000
Household financial assets3 $75,500 $500,000 $200,000 $330,000
Percentage of households
  Household primary or co-decisionmaker for saving and investing
     Married or living with a partner 58 73 73 53
     Widowed 9 4 5 $90,000
     Four-year college degree or more 32 64 49 $330,000
     Employed (full- or part-time) 60 72 77 72
     Retired from lifetime occupation 28 28 23 29
   Household owns
     IRA(s) 34 75 62 63
     DC retirement plan account(s) 46 74 85 72

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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 2013.
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-nine percent of ETF-owning households were willing to take substantial or above-average investment risk for substantial or above-average gain in 2014, 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 82 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, mid-2014

Figure 3.12

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