Asia Etrading Education Exchange Traded Funds (ETFs)
Exchange-traded funds (or ETFs) are open-ended collective investment schemes, traded as shares on most global stock exchanges. Typically, ETFs try to replicate a stock market index such as the S&P 500 or Hang Seng Index, a market sector such as energy or technology, or a commodity such as gold or petroleum.
The legal structure and makeup varies around the world, however the major common features include:
* An exchange listing and ability to trade continually;
* They are index-linked rather than actively managed;
* The ability to handle contributions and redemptions on an in-kind basis (typically in large blocks of shares only); and
* Their 'value' (but not necessarily the price at which they trade—they can trade at a 'premium' or 'discount' to the 'underlying' assets' value) derives from the value of the 'underlying' assets comprising the fund.
These qualities provide ETFs with some significant advantages compared with traditional open-ended collective investments. The ETF structure allows for a diversified, low cost, low turnover index investment. This appeals to both institutional and retail investors both for long term holding and for selling short and hedging strategies.
Index basis
Many current U.S. ETFs are based on some index; for example, SPDRs (Standard & Poor's Depository Receipts, or "Spiders") are based on the S&P 500 index. The index is generally determined by an independent company; for example, Spiders are run by State Street, while the S&P 500 is calculated by Standard & Poor's. Sometimes, a proprietary index is used.
Although the SEC states flatly that an ETF is "a type of investment company whose investment objective is to achieve the same return as a particular market index," this is no longer reality. The development of investment structures has progressed more quickly than the SEC's website.
A series of ETFs introduced by Powershares in 2006 no longer follow the traditional definition. These funds, while correlating to the performance of the S&P 500, NASDAQ 100, DJIA, and S&P 400 Midcap, do not attempt to merely achieve the same return as the underlying index. The twelve funds attempt to either achieve the daily performance of the designated benchmark times two, times negative one, or times negative two. They are ETFs with integrated leverage.
Another example of an innovative ETF that has broken the classic mold is the oil futures ETF: USO. This ETF tracks the performance of the Western Texas Intermediate light sweet crude. This is not a benchmark, but a traded commodity.
Rydex has taken a different direction and worked with S&P to create new, equal-weight benchmarks for their proprietary benchmarks. These "benchmarks" are rebalanced quarterly.
Creation and redemption of shares
Rather than the fund manager dealing directly with shareholders, institutional investors will create a portfolio of shares identical to the ETF and loan them to the fund manager. The portfolio is then incorporated in the ETF and ETF shares are created. Typically a creation unit consists of 50,000 shares.
ETF shares are sold and resold freely among large investors on the open market. If they purchase a sufficient amount of shares, the investor can exchange one full creation unit of ETF shares for the underlying shares of stock. The ETF creation unit is then destroyed and the underlying stocks are delivered out of the trust.
The attraction of this method of dealing for the ETF fund manager is that the institutional investors cover the dealing costs in purchasing the required shares to make up the portfolio. The reason they are willing to do this is the profit they can make by arbitrage based on the trading price of shares on the secondary market. Shares will trade at a premium to net asset value if demand is high and at a discount to net asset value if demand is low. These market drivers provide the efficiency for the ETF managers as the bulk buying power of the institutional investors allows them to avoid the expense of mass share creation and deletion.
Actively managed ETF
People have talked about 'actively managed ETF' for a long time[citation needed], based somewhat on analogy with mutual funds. Others feel that such a thing is contradictory and nonsensical. ETFs are mainly exchanged 'in-kind'; holdings of ETFs are made available daily. This is felt to be a strength since no one knows more than anyone else about what the fund holds. If holdings were secret, it would be difficult to buy an ETF, since one would not know what shares to transfer; similarly, if one sells and gets the component shares, the holdings would not be secret. This seems to cause problems for an actively managed fund. Similarly, arbitrageurs are less likely to bid aggressively if they don't know what they are buying and selling. All of this is in contrast to mutual funds, which are allowed to keep holdings unknown for many months.
Lastly, some people think that owners of ETFs are more sophisticated, therefore more likely to be proponents of indexing. So it's not obvious who would buy such a thing.
Usage
Today ETFs present a viable alternative investment option to traditional open-ended mutual funds, especially open-ended index funds. There are many available ETFs that attempt to track all kind of indexes (such as large-cap, mid-cap, small-cap, etc), specialties (such as value and growth), industries, countries, precious metals and other commodities or commodity indices like GSCI; and more are being developed for the future.
History
The first ETF was introduced on the Toronto Stock Exchange in 1989.
There are over one hundred ETFs traded on the American Stock Exchange, with more in other countries. ETFs have been gaining popularity ever since they were introduced on the American Stock Exchange in the mid 1990s, beginning with SPDR in 1993. ETFs are attractive to investors because they offer the diversification of mutual funds with the features of a stock. The popularity is likely to increase as new and more innovative ETFs are introduced.
The original ETFs were set up as competitors to open-ended index funds, and subsequent ETFs have usually followed in their footsteps: they typically have very low expense ratios compared to actively managed mutual funds. They also have a lower turnover ratio, which tends to be more tax-favorable.
ETF managers such as Barclays and State Street typically have the most money under management of all companies. This can raise corporate governance issues as often the largest owner of a company is a money management company which simply owns that company as part of trying to own all companies based on a belief that this strategy will do better than most others.
ETFs vs. open-ended funds
An advantage of mutual funds is that they have lower costs if you only invest a little bit of money, or invest small monthly or quarterly amounts. Since ETFs are traded on the stock market, every trade has commission costs. Many mutual funds do not have such costs. If an investor likes to invest, say, $100 or $500 every month, mutual funds are likely to cost less.
There are many advantages to ETFs, and these advantages will likely increase over time. Most ETFs have a lower expense ratio than comparable mutual funds. Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.
In the US only, ETFs are usually more tax-efficient than mutual funds in some jurisdictions [1]. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to their shareholders by the end of the quarter. This can happen when stocks are added to and removed from the index, or when a large number of shares are redeemed (such as during a panic). These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF on the stock market, as they would a stock), so that investors generally only realize capital gains when they sell their own shares.
Perhaps the most important, although subtle, benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many ETFs have the capability for options (puts and calls) to be written against them. Mutual funds do not offer those features.
For example, an investor in an open-ended fund can only purchase or sell at the end of the day at the mutual fund's closing price. This makes stop-loss orders much less useful for open-ended funds – if your broker even allows them. An ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis.
A more subtle advantage is that ETFs, like closed-ended funds, are immune from some market timing problems that have plagued open-ended mutual funds. In these timing attacks, large investors trade in and out of an open ended fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term unit holders. With an ETF (or closed-ended fund) such an operation is not possible--the underlying assets of the fund are not affected by its trading on the market.
ETFs trading on the Korea Exchange
- KODEX 200
- KOSEF
- KODEX Baedang
- KODEX KRX 100
- KODEX Star
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