02) Exchange-Traded Funds: Background

by · October 16, 2010

The very first US Exchange-Traded Funds (ETF) originally tracked a wide market index. It was created when State Street Global Advisors introduced the S&P 500 Depositary Receipts (SPDR), fondly called “spiders”, into the market. Today, more ETFs are seen with more specific indexes such as fixed income, commodities and currencies.

ETFs are similar to mutual funds but are a newer form investment vehicle. They represent shares of ownership of a unit investment trust (UIT). The UIT holds portfolios of stocks, bonds, commodities and currencies. The following are the characteristics of an ETF:

  • An ETF puts together the assets of investors with a set of defined objectives for investing, and is handled by a professional manager. A prospectus, which is a legal document that states the details of the investment (sort of like a product description), is also provided.
  • Investors who want to purchase an ETF can get shares from a stock exchange in the same way that other listed stocks are acquired. ETFs mostly are passively managed, although there are already a few ETFs that are being actively managed.
  • Unlike mutual funds, the creation and redemption process of ETFs does not involve cash.

Creation Process

An ETF is simply a security certificate that provides proof over the legal right of ownership of a part of a “basket” of invdividual stock certificates. The creation requires a plan detailing procedures and the composition of the ETF. The plan must then be submitted by a fund manager to the Securities and Exchange Commission (SEC). Normally, only big and experienced money management firms can create and manage ETFs.

The creation offcially starts with an authorized specialist or market maker. The specialist gathers the  minimum basket of stocks that is enough to buy 10,000 tp 50,000 shares of the ETF. This minimum basket is known as a creation unit. The basket is then sent to a custodial bank, after which it is sent back to the market maker for safekeeping.

Redemption Process

The ETF shares are redeemed via an authorized participant, who buys a large portion of ETFs, forwards it to a custodial bank, and then receives an equivalent basket of individual stocks.

There are usually two ways to dispose an ETF:

  • Sell it on the secondary market.
  • Submit the shares to the ETF fund in exchange for the equivalent shares of stock.

What commonly happens is that the individual investors will opt to sell it because there are limitations placed on the redemption of ETF shares.

Arbitrage

A nice thing about ETFs is the chance for arbitrage. When the prices of an ETF start to deviate from the net asset value (NAV) of the component stocks, the participants can intervene and take profit on the differences in two ways:

  • Buy ETF shares on the open market if it is trading at a price lower than the NAV. Form creation units, redeem the units to a custodial bank, receive the equivalent securities and sell it for a profit.
  • Buy the underlying securities of the ETF on the open market if it is trading at a price higher than the NAV. It is then redeemed for creations units, and sell the ETF shares for a profit.

This intervention process keeps ETF prices close to the NAV of the underlying securities always.

Well-known ETF Families

Standard & Poor’s Depositary Receipts (SPDRs)

SPDRs are managed by State Street Global Advisors, among which the SPDR S&P 500 ETF (SPY) is  the most popular. There are also ETFs that track major S&P 500 sectors. These are called Select Sector SPDRs.

iShares

This particular ETF is a brand of Barclays Global Investors. The latter is the largest providers of ETFs in the whole world.

PowerShares

This is a newer ETF family that offers equity ETFs with a broad market coverage. It is well known for the Nasdaq 100 ETF,  or QQQQ. It also uses dynamic indexing to find the best performing stocks within each index for its quantitative-based ETF.

Vanguard Index Participation Receipts (VIPERs)

This is an ETF issued by Vanguard as the name implies. Vanguard is well known for its mutual funds. It offers different ETFs, including international and bond ETFs.