Exchange Traded Funds (ETFs)
Exchange Traded Funds (ETFs) are increasingly popular investment vehicles. Before you decide to invest, there are some basic questions you should consider in order to make an informed investment decision.
What are Exchange Traded Funds?
An ETF is an investment product that allows an investor to buy and sell shares in a single security that represents a fractional ownership of a portfolio of securities. Legally, ETFs are open-ended investment companies or unit investment trusts that are registered under the Investment Company Act of 1940.
ETFs are one type of structured exchange-traded product. There are other types as well, but they do not share all the characteristics of ETFs, even though they may be referred to as such in the popular press and on some websites. Examples of these other investment products include exchange traded notes (ETNs), equity linked notes, closed end funds and exchange traded vehicles (ETVs), among others.
ETFs are similar to index mutual funds in that they replicate the returns of predefined stock indexes.
What kinds of ETFs are available?
The first ETF, SPDR Trust, was listed in 1993 with an underlying portfolio designed essentially to replicate the performance of the S&P 500 index. Since then over 700 ETFs have been introduced that allow investors to gain exposure to a wide range of investment strategies including broad stock indexes, industry sectors, fixed income indexes and international and global indexes.
Recently, ETFs have introduced investment objectives that attempt to replicate a multiple or the inverse of the daily return of an underlying index. For example, one fund replicates twice the daily return of the Dow Jones Industrial Average. The "short" or "inverse" ETFs replicate the inverse of the daily returns of the underlying index.
Another new type of investment offered in the ETF structure is the actively managed portfolio. Unlike traditional ETFs, which are designed to track an index, actively managed ETFs permit the fund manager to buy and sell securities and derivatives according to a stated strategy, described in the prospectus. As a condition of operations, the portfolio or fund holdings are disclosed daily on the fund's website.
How are ETFs traded?
ETFs are listed on a national securities exchange; they can be bought and sold like common stocks throughout the trading day. Individual investors may purchase or sell an ETF through a stock brokerage account. Investors may enter the same types of orders that are placed for shares of stock (including, for example, market and limit orders). There are also listed options on some ETFs.
What ETF types or categories are available?
- US Equity ETF
All constituents trade on a US exchange.
- Global Equity ETF
One or more of the constituents do not trade on a US Exchange.
- Fixed Income ETF
The constituent list contains government and / or corporate debt instruments.
- Commodity Based ETF
This classification of ETF has no constituents but is structured to reflect the valuation of a commodity such as gold, silver, oil or interest rates.
- Exchange Traded Notes
A type of unsecured, unsubordinated debt security that was first issued by Barclays Bank PLC. The purpose of ETNs is to create a type of security that combines both the aspects of bonds and exchange traded funds (ETF). Similar to ETFs, ETNs are traded on a major exchange.
- Closed End Fund
While often very similar in structure and trading to many ETFs, these funds (sometimes referred to as Closed End ETFs) are considered traditional mutual funds but with a fixed number of outstanding shares.
Interest in ETFs has soared in recent years, and the ETF industry has responded by creating new funds. In fact, it is hard to find an industry or market segment that is not represented by one or more ETFs. Observing ETF price trends and comparing returns over shorter and longer time frames, you can see which market segments are rotating into, or out of, favor.
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