ETFs are a convenient, cost-effective tool for investors seeking to gain or shed exposure to broad market indexes, particular sectors or geographical regions, or specific rules-based investment strategies. 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, net share issuance of ETFs has totaled $2.1 trillion. As investor demand has increased, sponsors have offered more ETFs with a greater variety of investment objectives. With $3.4 trillion in assets at year‑end 2017, the US ETF industry remained the largest in the world. Though ETFs share some basic characteristics with mutual funds, there are key operational and structural differences between the two types of investment products.
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 are 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 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 or an inverse (or a multiple of an inverse) of their indexes. At year-end 2017, there were 1,569 index-based ETFs with $3.3 trillion in total net assets.
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 strategy. At year-end 2017, 194 actively managed ETFs—with $45 billion in assets—were registered with the SEC as investment companies.
Exchange-Traded Funds Resource Center
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 such as derivatives or bank loans. 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 of 1940, 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.
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.
Understanding Exchange-Traded Funds: How ETFs Work
The US ETF market—with 1,832 funds and $3.4 trillion in total net assets at year-end 2017—remained the largest in the world, accounting for 72 percent of the $4.7 trillion in ETF total net assets worldwide (Figures 4.1 and 4.2).
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 4.2). At year-end 2017, 2 percent of total net 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.
The United States Has the Largest ETF Market
Percentage of total net assets, year-end 2017
Sources: Investment Company Institute and ETFGI
Mutual Funds and ETFs’ Share of the Corporate Bond Market: What’s the Right Answer?
Total Net Assets and Number of ETFs
Billions of dollars; year-end, 2008–2017
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 exclude ETFs that invest primarily in other ETFs. Components may not add to the total because of rounding.
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 that contain 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.
The creation or redemption of ETF shares—activity directly involving the ETF’s underlying securities—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 4.3). 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. 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.
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. This generally occurs 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.
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.
Creation of ETF Shares
Note: The creation basket represents a specific list of securities, cash, and/or other assets.
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.
The Creation and Redemption Process and Why It Matters
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 (NSCC) and the Depository Trust Company (DTC).
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. Rather, APs typically derive their compensation from acting as dealers in ETF shares. Also, APs 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 entities other than APs provide liquidity in the form of offering quotes to both buy and sell ETF shares. These other liquidity providers also help facilitate trading of ETF shares in the secondary market. Domestic equity ETFs have the most liquidity providers (Figure 4.4). 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.
The Secondary Market Has Many ETF Liquidity Providers
1 For this figure, liquidity provider is 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
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 its shares at a price that approximates its 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.
Understanding the Regulation of Exchange-Traded Funds Under the Securities
Exchange Act of 1934
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 (on 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 (on 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 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.
ETF investors trading in the secondary market (e.g., on an exchange) do not interact with the ETF directly and, for the most part, 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, retail investors generally can access them only in the secondary market. Many ETF investors trading in the secondary market generally are not motivated by arbitrage. They are using ETFs to gain or reduce exposure to particular asset classes or investment strategies. Thus, ETFs provide investors with an efficient means to transfer risk.
Does Liquidity in ETFs Depend Solely on Authorized Participants?
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 4.5). 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 75 percent, respectively). On average, secondary market trading is a smaller proportion of total trading for bond ETFs (79 percent) than for equity ETFs (89 percent). Because bond ETFs are a growing segment of the industry, many small bond ETFs tend to have less-established secondary markets. As their total net assets increase, the secondary market for bond ETFs is likely to deepen.
Most ETF Activity Occurs on the Secondary Market
Percentage of secondary market activity1 relative to total activity;2 daily, January 2, 2015–December 29, 2017
1 Secondary market activity is measured as average daily dollar volume of ETF shares traded in each category over the 755 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 755 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. During 2017, the effective yield on the ICE BofAML US High Yield Master II Index ranged between 5.43 percent and 6.19 percent, at times increasing abruptly (Figure 4.6). For example, in early 2017, the index’s yield had drifted down to 5.61 percent on March 1, 2017, then ratcheted up quickly to 6.19 percent by March 14, 2017. When bond yields increase, prices on existing bonds—such as those that funds hold in their portfolios—and bond ETFs fall. Sellers of high-yield bond ETFs were able to find willing buyers in the secondary market during this two-week period despite declining prices for high-yield bond ETFs. The weekly dollar volume of high-yield bond ETFs that were traded on the secondary markets (blue bars, Figure 4.6) increased to an average of $12.7 billion in the first two weeks of March compared with an average of $6.7 billion in the prior nine weeks. In addition, redemptions of high-yield bond ETFs (green bars, Figure 4.6) were fairly modest in the first two weeks of March, totaling $3.5 billion, or 6.1 percent of total net assets, in high-yield bond ETFs as of the end of February 2017.
Secondary Market Trading of High-Yield Bond ETFs Increased When Yields Rose in 2017
December 29, 2016–December 29, 2017*
* Data for the effective yield of the ICE BofAML US High Yield Master II Index are daily. Data for high-yield bond ETFs’ secondary market dollar volume and net share issuance are week-ended Wednesday.
High-Yield Bond ETFs: A Source of Liquidity
This basic pattern repeated itself later in 2017 when the effective yield on the index jumped from 5.54 percent on November 1, 2017, to 6.02 percent on November 15. At the same time, trading in high-yield bond ETFs increased, peaking at $16.1 billion for the week ended November 14. As in the episode earlier in the year, redemptions of high-yield bond ETFs were limited during this two-week period—amounting to $2.9 billion, or 4.6 percent of their October 2017 total net assets.
The relative magnitudes of secondary market trading in and net share issuance of high-yield bond ETFs are also noteworthy—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, high-yield bond ETFs provide an efficient means of transferring risk among themselves while limiting the impact on the underlying high-yield bond market.
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. Total net assets in ETFs accounted for about 15 percent of total net assets managed by investment companies at year-end 2017. For 2017 as a whole, net share issuance of ETF shares (which includes reinvested dividends) hit a record $471 billion (Figure 4.7).
Record Net Share Issuance of ETFs in 2017
Billions of dollars; annual, 2008–2017
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 share issuance include reinvested dividends. Data exclude ETFs that invest primarily in other ETFs. Components may not add to the total because of rounding.
In 2017, net share issuance of ETFs increased across all broad asset classes, except commodities (Figure 4.8). Demand for global and international equity ETFs surged in 2017 with net share issuance totaling $160 billion, up from $20 billion in 2016 and $110 billion in 2015. This rebound in demand likely reflected the strong performance in international stocks,* which returned 28 percent in 2017, up from only 5 percent in 2016, and a depreciation (7 percent) in the value of the US dollar,† which generally increases the attractiveness of international investments to US investors. Net share issuance of broad-based domestic equity ETFs remained strong in 2017, with $156 billion in net new shares issued, up slightly from $148 billion in 2016. Double-digit return performance of domestic stocks over the previous two years—19 percent in 2017 and 11 percent in 2016—likely boosted demand for domestic equity ETFs.‡ Demand for bond and hybrid ETFs strengthened further in 2017, with net new share issuance totaling $123 billion, up from $85 billion in 2016.
* As measured by the MSCI All Country World Daily ex-US Gross Total Return Index.
† As measured by the Trade Weighted US Dollar Index: Broad.
‡ As measured by the Wilshire 5000 Total Return Index (float-adjusted).
Net Share Issuance of ETFs by Investment Classification
Billions of dollars; annual, 2015–2017
1 Bond ETFs represented 98 percent of net issuance in the bond and hybrid category in 2017.
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 share issuance include reinvested dividends. Data exclude ETFs that invest primarily in other ETFs.
ETFs have been available for 25 years, and in that time, large-cap domestic equity ETFs have accounted for the largest proportion of ETF total net assets. At year-end 2017, assets in large-cap domestic equity ETFs totaled $927 billion, or 27 percent, of ETF assets (Figure 4.9). Fueled by strong investor demand over the past few years, bond and hybrid ETFs held 16 percent ($561 billion) of ETF assets. International equity ETFs accounted for 14 percent, or $477 billion of ETF total net assets.
Plenty of Players Provide Liquidity for ETFs
Total Net Assets of ETFs Were Concentrated in Large-Cap Domestic Stocks
Billions of dollars, year-end 2017
1 This category includes international, regional, and single country ETFs, but excludes emerging market ETFs.
2 Bond ETFs represented 99 percent of total net assets in the bond and hybrid category in 2017.
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 exclude ETFs that invest primarily in other ETFs.
ICI Seeks Market Improvements for ETFs and Their Investors
Increased investor demand for ETFs has led to a rapid increase in the number of ETFs created by fund sponsors, with 1,852 new ETFs offered to investors in the past decade (Figure 4.10). In 2016 and 2017, domestic equity ETFs accounted for about half of newly offered ETFs. International and global equity ETFs accounted for about one-quarter of new ETFs in 2017. Few ETFs had been liquidated until 2008 when market pressures appeared to come into play and sponsors began liquidating ETFs that had failed to attract sufficient demand. 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 2017, ETF liquidations rose to 114, as sponsors eliminated some small international equity ETFs from their lineups.
Number of ETFs Entering and Exiting the Industry
Note: Data include ETFs not registered under the Investment Company Act of 1940 but exclude ETFs that invest primarily in other ETFs.
An estimated 7.8 million, or about 6 percent of, US households held ETFs in mid-2017. Of households that owned mutual funds, an estimated 13 percent also owned ETFs. ETF-owning households tended to include affluent investors who owned a range of equity and fixed-income investments. In mid-2017, 95 percent of ETF-owning households also owned equity mutual funds, individual stocks, or variable annuities (Figure 4.11). Sixty-nine percent of households that owned ETFs also held bond mutual funds, individual bonds, or fixed annuities. In addition, 44 percent of ETF-owning households owned investment real estate.
ETF-Owning Households Held a Broad Range of Investments
Percentage of ETF-owning households holding each type of investment, mid-2017
|Equity mutual funds, individual stocks, or variable annuities (total)||95|
|Bond mutual funds, individual bonds, or fixed annuities (total)||69|
|Mutual funds (total)||91|
|Fixed or variable annuities||33|
|Investment real estate||44|
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 4.12). 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.
Characteristics of ETF-Owning Households
|All US households||Households owning ETFs||Households owning mutual funds||Households owning individual stocks|
|Age of head of household1||51||52||51||53|
|Household financial assets3||$90,000||$500,000||$200,000||$350,000|
|Percentage of households|
|Household primary or co-decisionmaker for saving and investing|
|Married or living with a partner||57||77||72||72|
|College or postgraduate degree||34||68||51||57|
|Employed (full- or part-time)||60||68||74||69|
|Retired from lifetime occupation||29||29||23||31|
|DC retirement plan account(s)||48||81||85||72|
1 Age is based on the sole or co-decisionmaker for household saving and investing.
2 Total reported is household income before taxes in 2016.
3 Household financial assets include assets in employer-sponsored retirement plans but exclude the household’s primary residence.
The Liquidity Provided by ETFs Is No Mirage
ETF-owning households also exhibit more willingness to take investment risk (Figure 4.13). Fifty-two percent of ETF-owning households were willing to take substantial or above-average investment risk for substantial or above-average gain in 2017, compared with 22 percent of all US households and 34 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 (Figure 4.9). Investors who are more willing to take investment risk may be more likely to invest in equities.
ETF-Owning Households Are Willing to Take More Investment Risk
Percentage of all US households, mutual fund–owning households, and ETF-owning households; mid-2017