Back to Top

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. With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives. While ETFs share some basic characteristics with mutual funds, key operational and structural differences remain 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. Most ETFs are structured as open-end investment companies (open-end funds) or unit investment trusts, but other structures also exist primarily for ETFs that invest in commodities, currencies, and futures.

ETFs have been available as an investment product for 20 years. 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 that meet certain requirements. These actively managed ETFs must disclose each business day 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.

Total Net Assets of ETFs

By the end of 2012, the total number of index-based and actively managed ETFs had grown to 1,194, with total net assets of more than $1.3 trillion (Figure 3.1).

The vast majority of assets in ETFs are in funds registered with and regulated by the SEC under the Investment Company Act of 1940. At year-end 2012, 9 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 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

Total Net Assets and Number of ETFs1

Billions of dollars, year-end, 2001–2012

Figure 3.1

Download an Excel file of this data.

1Data for ETFs that invest primarily in other ETFs are excluded from the totals.
2The funds in this category are not registered under the Investment Company Act of 1940 and invest primarily in commodities, currencies, and futures.
3The funds in this category are registered under the Investment Company Act of 1940.
Note: Components may not add to the total because of rounding.

Creation of an ETF

An ETF originates with a sponsor, the company or financial institution which 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.

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. In theory, an actively managed ETF could trade its portfolio securities regularly. In practice, however, most actively managed ETFs tend to trade only weekly or monthly for a number of reasons, including minimizing the risk of other market participants front-running their trades.

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 3.2). 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 from 25,000 to 200,000 shares. 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.

Figure 3.2

Creation of an ETF

Figure 3.2

Download an Excel file of this data.

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 governed by the Investment Company Act of 1940 like mutual funds and is most commonly structured as an open-end investment company. For example, 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 six 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 9 percent of total net assets managed by investment companies at year-end 2012. Net issuance of ETF shares in 2012 amounted to $185 billion, exceeding the previous record of $177 billion set in 2008 (Figure 3.3).

FIGURE 3.3

Net Issuance of ETF Shares1

Billions of dollars, 2001–2012

Figure 3.3

Download an Excel file of this data.

1Data for ETFs that invest primarily in other ETFs are excluded from the totals.
2The funds in this category are not registered under the Investment Company Act of 1940 and invest primarily in commodities, currencies, and futures.
3The funds in this category are registered under the Investment Company Act of 1940.
Note: Components may not add to the total because of rounding.

In 2012, investor demand for ETFs within all asset classes increased, with demand for global and international equity ETFs more than doubling from 2011 (Figure 3.4). Global and international equity ETFs saw net issuance of $52 billion in 2012, up from $24 billion in 2011, and net issuance of broad-based domestic equity ETFs increased to $58 billion in 2012 from $35 billion in 2011. In 2012, bond and hybrid ETFs saw net issuance of $53 billion, up from $46 billion in 2011. Domestic sector equity ETFs experienced net issuance of $14 billion in 2012, up from $10 billion in 2011, and net issuance of commodity ETFs increased to $9 billion in 2012 from $3 billion in 2011.

Figure 3.4

Net Issuance of ETF Shares1 by Investment Classification

Billions of dollars, 2010–2012

Figure 3.4

Download an Excel file of this data.

1Data for ETFs that invest primarily in other ETFs are excluded from the totals.
2This category includes funds both registered and not registered under the Investment Company Act of 1940.
3Bond ETFs represented 99.53 percent of flows in the bond and hybrid category in 2012.
4This category includes funds—both registered and not registered under the Investment Company Act of 1940—that invest primarily in commodities, currencies, and futures.

Large-cap domestic equity ETFs continued to account for the largest proportion of all ETF assets—22 percent, or $293 billion (Figure 3.5), at year-end 2012. Strong investor demand for bond and hybrid ETFs over the past five years has propelled this asset class to the second-largest category, accounting for 18 percent ($244 billion) of all ETF assets. Emerging markets ETFs, and global and international equity ETFs more generally, also experienced strong investor demand over the past five years; emerging markets ETFs were the third-largest asset class with 13 percent ($169 billion) of all ETF assets.

Figure 3.5

Total Net Assets of ETFs1 Were Concentrated in Large-Cap Domestic Stocks

Billions of dollars, year-end 2012

Figure 3.5

Download an Excel file of this data.

1Data for ETFs that invest primarily in other ETFs are excluded from the totals.
2This category includes funds both registered and not registered under the Investment Company Act of 1940.
3This category includes international, regional, and single country ETFs.
4This category includes funds—both registered and not registered under the Investment Company Act of 1940—that invest primarily in commodities, currencies, and futures.
5Bond ETFs represented 99.73 percent of the assets in the bond and hybrid category in 2012.

Increased investor demand for ETFs led to a rapid increase in the number of ETFs created by fund sponsors in the past decade (Figure 3.6). During the period of 2003 to 2012, 1,336 ETFs were created—the peak years came in 2007, with 270 new funds, and 2011, with 226 new funds. 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. Nevertheless, on net, there were 60 more ETFs at year-end 2012 compared to year-end 2011, bringing the total number of ETFs to 1,194.

Figure 3.6

Number of ETFs1

2001–2012

  Created Liquidated Total at year-end
2001 22 0 102
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 7972
2010 177 51 923
2011 226 15 1,134
2012 141 81 1,194

Download an Excel file of this data.

1ETF data include ETFs not registered under the Investment Company Act of 1940 but exclude ETFs that invest primarily in other ETFs.
2In 2009, two ETFs converted from holding securities directly to investing primarily in other ETFs.

As demand for ETFs has grown, ETF sponsors have offered not only a greater number of funds, but also a greater variety of investment objectives. Sponsors have introduced ETFs that invest in particular market sectors, industries, or commodities (either directly or through the futures market). At year-end 2012, there were 301 sector and commodity ETFs with $255 billion in assets. While commodity ETFs only made up 26 percent of the number of sector and commodity ETFs (Figure 3.7), they accounted for 47 percent of the total net assets of these funds (Figure 3.8). Since their introduction in 2004, commodity ETFs have grown from just over $1 billion to $120 billion by the end of 2012. Strong net issuance and surging gold and silver prices were the primary drivers behind the increase in assets during this time. In 2012, 82 percent of commodity ETF assets tracked the price of gold and silver, by either holding the metals directly or investing in the futures markets.

Figure 3.7

Number of Commodity and Sector ETFs1

Percent, year-end 2012

Figure 3.7

Download an Excel file of this data.

1Data for ETFs that invest primarily in other ETFs are excluded from the totals.
2This category includes funds—both registered and not registered under the Investment Company Act of 1940—that invest primarily in commodities, currencies, and futures.


Figure 3.8

Total Net Assets of Commodity and Sector ETFs1

Percent, year-end 2012

Figure 3.8

Download an Excel file of this data.

1Data for ETFs that invest primarily in other ETFs are excluded from the totals.
2This category includes funds—both registered and not registered under the Investment Company Act of 1940—that invest primarily in commodities, currencies, and futures.

ETF sponsors continued building on recent innovations by launching additional actively managed ETFs and ETFs that are structured as funds of funds, both of which were first introduced in 2008. During 2012, 12 actively managed ETFs were launched, bringing the total number of actively managed ETFs to 44,* with more than $10 billion in assets at year-end, excluding ETF funds of funds. ETF funds of funds are ETFs that hold and invest primarily in shares of other ETFs. At year-end 2012, there were 45 ETF funds of funds—including 14 actively managed ETF funds of funds that launched in 2012—with $2.2 billion in assets.

* This total includes one non–1940 Act ETF.

Characteristics of ETF-Owning Households

An estimated 3.4 million, or 3 percent of, U.S. households held ETFs in 2012. Of households that owned mutual funds, an estimated 6 percent also owned ETFs. ETF-owning households tended to include affluent, experienced investors who owned a range of equity and fixed-income investments. In 2012, 97 percent of ETF-owning households also owned stocks, either directly or through equity mutual funds or variable annuities (Figure 3.9). Sixty-eight percent of households that owned ETFs also held bonds, bond mutual funds, or fixed annuities. In addition, 45 percent of ETF-owning households owned investment real estate.

Figure 3.9

ETF-Owning Households Held a Broad Range of Investments

Percentage of ETF-owning households holding each type of investment, May 2012

Equity mutual funds, equities, or variable annuities (total) 97
Bond mutual funds, bonds, or fixed annuities (total) 68
Mutual funds (total) 92
   Equity mutual funds 86
   Bond mutual funds 62
   Hybrid mutual funds 51
   Money market funds 65
Individual equities 77
Bonds 29
Fixed or variable annuities 27
Investment real estate 45

Download an Excel file of this data.

Note: Multiple responses are included.

Some characteristics of retail ETF owners are similar to those of retail stock owners because a large number of households that owned ETFs also owned stock. For instance, households that owned ETFs—like households 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 3.10). However, ETF-owning households also exhibit some characteristics that distinguish them from households owning individual equities. For example, ETF-owning households tended to have higher incomes, greater household financial assets, and were more likely to be headed by college-educated individuals.

Figure 3.10

Characteristics of ETF-Owning Households

May 2012

  All U.S.
households
Households
owning ETFs
Households
owning individual
equities
Median
Age of head of household1 50 49 53
Household income2 $50,000 $125,000 $87,500
Household financial assets3 $62,500 $500,000 $250,000
Percentage of households
Household primary or co-decisionmaker for saving and investing
Married or living with a partner 61 75 73
Widowed 10 2 7
Four-year college degree or more 31 66 52
Employed (full- or part-time) 58 72 66
Retired from lifetime occupation4 30 25 30
Household owns
IRA(s) 40 90 69
DC retirement plan account(s) 51 69 74

Download an Excel file of this data.

1Age is based on the sole or co-decisionmaker for household saving and investing.
2Total reported is household income before taxes in 2011.
3Household financial assets include assets in employer-sponsored retirement plans but exclude the household’s primary residence.
4The head of household was considered retired if they responded affirmatively to the question: “Are you retired from your lifetime occupation?”

Also, more than half of ETF-owning households exhibit a willingness to take on substantial or above average investment risk (Figure 3.11). This appetite for risk remained fairly steady through the market turmoil of the past four years, although the share willing to take substantial investment risk rose from 10 percent in 2008 to 21 percent in 2012.

FIGURE 3.11

ETF-Owning Households’ Willingness to Take Investment Risk

Percentage of ETF-owning households; May, 2008–2012

Figure 3.11

Download an Excel file of this data.


Copyright © 2013 by the Investment Company Institute. All rights reserved.