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A LETTER FROM ICI'S
CHIEF ECONOMIST

ICI RESEARCH:
STAFF AND PUBLICATIONS

SECTION 1:
OVERVIEW OF
U.S.-REGISTERED INVESTMENT COMPANIES

SECTION 2:
RECENT MUTUAL FUND TRENDS

SECTION 3:
EXCHANGE-TRADED FUNDS AND INDEX MUTUAL FUNDS

SECTION 4:
CLOSED-END FUNDS

SECTION 5:
MUTUAL FUND FEES AND EXPENSES

SECTION 6:
CHARACTERISTICS OF MUTUAL FUND OWNERS

SECTION 7:
THE ROLE OF MUTUAL FUNDS IN RETIREMENT AND EDUCATION SAVINGS

DATA TABLES

APPENDIX A:
HOW MUTUAL FUNDS AND INVESTMENT COMPANIES OPERATE

APPENDIX B:
ICI STATISTICAL RELEASES AND RESEARCH PUBLICATIONS

TIMELINE:
SIGNIFICANT EVENTS IN FUND HISTORY

FACT BOOK ARCHIVE

Index mutual funds and most ETFs are similar in that they both hold investment portfolios that track designated indexes and seek to achieve the same investment return as those indexes. Investors—both retail and institutional—continue to turn to ETFs and index mutual funds as investment options in their portfolios. Although ETFs and index mutual funds have marked similarities, there remain key differences between the two types of investment products.

What Is an ETF?

ETFs are a relatively recent innovation to the investment company concept. The first ETF—a broad-based domestic equity fund tracking the S&P 500—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. By the end of 2007, the total number of ETFs had grown to 629 (Figure 3.1), and total assets reached $608 billion (Figure 3.2).

Figure 3.1

Number of ETFs

(1993–2007)

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*ETFs not registered under the Investment Company Act of 1940
Sources: Investment Company Institute and Strategic Insight Simfund

Figure 3.2

Net Assets of ETFs

(millions of dollars, 1993–2007)

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*ETFs not registered under the Investment Company Act of 1940
Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute and Strategic Insight Simfund

An ETF originates with a sponsor, which chooses the ETF's target index, determines which securities will be included in the "basket" of securities, and decides how many ETF shares will be offered to investors. ETF shares are created when an institutional investor deposits with the ETF fund or trust a pre-specified basket of securities, identical or nearly identical in composition to the securities in the ETF's target index (Figure 3.3). In return for this basket of securities, the ETF issues to the institutional investor a "creation unit" that consists of a specified number of ETF shares. The institutional investor ("creation unit holder") 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 stock exchanges, where investors can purchase them as they would stock of a publicly traded company. A creation unit is liquidated when an institutional investor returns to the ETF the specified number of shares in the creation unit; in return, the institutional investor receives a basket of securities reflecting the current composition of the ETF.

Figure 3.3

Creation of an exchange-traded fund

The vast majority of ETFs are registered investment companies. In 2007, 95 percent of total ETF assets were registered with the SEC under the Investment Company Act of 1940 (Figure 3.2). The remaining 5 percent of ETF assets, which are commodity-based, are not registered with or regulated by the SEC under the Investment Company Act of 1940. Those commodity-based ETFs that invest in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC), while those that invest solely in physical commodities are not regulated by the CFTC.

Key Differences Between ETFs and Mutual Funds

Index mutual funds and index-based ETFs are investment vehicles composed of the securities in their underlying indexes. As a result, the return of each type of fund tends to follow closely the return of its specific market index. Despite this similarity, key features differentiate index-based ETFs and index mutual funds.

One difference is in how retail investors buy and sell shares. Retail investors can buy and sell mutual fund shares through a variety of distribution channels, including through a broker-dealer or directly from a fund company. Also, mutual fund shares are not listed on stock exchanges. In contrast, retail investors can only buy or sell ETF shares on a stock exchange through a broker-dealer.

Pricing also differs between mutual funds and ETFs. For a mutual fund, the price at which investors buy and sell shares is equal to the fund's net asset value (NAV), less any commissions. The NAVs of both mutual funds and ETFs are calculated daily at the close of the markets. While investors can buy and sell mutual fund shares at any time throughout the day, all investors will receive the same transaction price (the NAV). 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. For example, 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 net asset value.

The price of an ETF share on a stock exchange is influenced by the forces of supply and demand. For example, when investor demand for an ETF increases, the ETF's share price will rise, perhaps exceeding the ETF's net asset value. ETFs are structured, however, so that large differences between their share prices and their NAVs are unlikely to persist. Third parties calculate and disseminate every 15 seconds a measure often called the Interday Indicative Value (IIV), which is a real-time estimate of a fund's NAV. When an ETF's share price is substantially above this indicative value, institutional investors may find it profitable to deliver the appropriate basket of securities to the ETF in exchange for ETF shares. In addition, both retail and institutional investors may find it profitable to take a short position in the ETF's shares or sell their holdings. When an ETF's share price is substantially below its indicative value, institutional investors may find it profitable to return ETF shares to the fund in exchange for the ETF's basket of securities. Retail and institutional investors may find it profitable to take a long position by purchasing the ETF's shares. These actions by investors help keep the market-determined price of

For more complete data on exchange-traded funds, see Section 2 in the Data Tables in the Statistics and Research section of this site.

Demand for ETFs and Index Mutual Funds

By year-end 2007, assets in registered ETFs and index mutual funds reached more than $1.4 trillion, and accounted for 11 percent of the total assets managed by all registered investment companies. Over the past decade, assets in these indexed products have increased more than eightfold—with much of the growth occurring in funds that track broad market indexes. ETFs and index mutual funds that track large-blend domestic equity indexes, such as the S&P 500, now manage about half of all assets invested in mutual funds and ETFs that focus on large-blend domestic stocks (Figure 3.4). ETFs and index funds are available in most other broad asset classes but, to date, have attracted less investor interest than those tied to indexes of large-blend domestic equity.

Figure 3.4

Assets of registered ETFs and Index Mutual Funds Are Concentrated in Large-Blend Domestic Equity

(billions of dollars, 2007)

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Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute and Morningstar

Exchange-Traded Funds

Demand for ETFs has accelerated as institutional investors have found ETFs to be a convenient vehicle for participating in, or hedging against, broad movements in the stock market. Retail investors and their financial advisers have also become aware of these investment vehicles. An estimated 2 percent of households, or 2.3 million, own ETFs. Of households that own mutual funds, an estimated 4 percent also own ETFs. In 2007, net issuance of ETF shares totaled $151 billion (Figure 3.5).

As demand for ETFs has grown, ETF sponsors have offered more funds with a greater variety of investment objectives. In the mid-1990s, ETF sponsors introduced funds that invested in foreign stock markets. More recently, sponsors have introduced ETFs that invest in particular market sectors or industries. Fund companies introduced 84 sector/industry ETFs, on net, in 2007 (Figure 3.1), and total net assets of these ETFs amounted to $93 billion at year-end (Figure 3.2). Approximately 40 percent of the increase in assets of sector/industry ETFs during the past few years is attributable to ETFs that track commodities. Assets of these non-registered ETFs have grown briskly, from slightly more than $1 billion in 2004 to nearly $29 billion in 2007. In 2007, approximately 65 percent of non-registered ETF assets tracked the price of gold through the spot and futures markets.

Figure 3.5

Net Issuance of ETF Shares

(millions of dollars, 1993–2007)

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*ETFs not registered under the Investment Company Act of 1940
Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute and Strategic Insight Simfund

ETFs that follow highly specialized indexes also are a recent innovation. These ETFs accounted for roughly 5 percent of total net issuance of ETFs in 2007 and 3 percent of total assets at year-end. And product innovation continues: the SEC has granted exemptive orders to several fund complexes allowing them to sponsor actively managed ETFs under certain conditions.

Assets of ETFs have grown rapidly since the late 1990s, with net issuance of new ETF shares contributing to much of this increase. From year-end 1998 through 2007, ETFs issued $484 billion in net new shares, and investor demand for broad-based domestic equity funds accounted for about half of the total net issuance (Figure 3.5). These equity ETFs issued $248 billion in net new shares during this nine-year period, and their assets reached $301 billion by year-end 2007 (Figure 3.2).

Demand for global and international ETFs has also risen sharply in recent years, mirroring an increase in investor interest in mutual funds investing in foreign markets. International and global ETFs issued $116 billion in net new shares over the period 2004 to 2007 (Figure 3.5), and assets of these funds stood at $180 billion at the end of 2007 (Figure 3.2).

Index Mutual Funds

Index mutual funds are also popular with investors. Almost 14 percent of U.S. households own at least one index mutual fund. Of households that own mutual funds, 31 percent own at least one index mutual fund. As of year-end 2007, 373 index funds (Figure 3.6) managed total assets of nearly $860 billion (Figure 3.7). Demand for index mutual funds picked up in 2007 with investors adding $63 billion in net new cash flow to these funds—surpassing the record flow of $61 billion in 1999 (Figure 3.8).

Despite the stronger inflow overall, mutual funds indexed to the S&P 500 continued to experience outflows. Almost half of the new money flowing to index mutual funds was invested in funds indexed to domestic equity indexes other than the S&P 500. As with ETFs, demand for global and international index mutual funds also was strong, with investors allocating about $17 billion in net new cash in these funds.

Figure 3.6

Number of Index mutual Funds

(1993–2007)

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Figure 3.7

Net Assets of Index mutual Funds

(millions of dollars, 1993–2007)

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Note: Components may not add to the total because of rounding.

Figure 3.8

Net New Cash Flow to Index mutual Funds

(millions of dollars, 1993–2007)

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Note: Components may not add to the total because of rounding.

Equity index funds account for the bulk of all index fund assets. About 87 percent of index mutual fund assets are invested in index funds that track either the S&P 500 index or other domestic and international equity indexes (Figure 3.7). Funds indexed to the S&P 500 manage 45 percent of all assets invested in index mutual funds. After ramping up fairly quickly in the latter half of the 1990s, the percentage of assets invested in equity index funds relative to all equity mutual fund assets has hovered around 11 percent for the past five years (Figure 3.9).

Figure 3.9

Equity Index mutual Fund Assets as a Percentage of Equity Mutual Fund Assets

(percent, 1985–2007)

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