ETF Primer
What is an ETF
Exchange traded funds (ETF's) are essentially mutual funds that trade during the day. The price you pay for a share in an ETF is determined by whatever price you agree to with the other person taking the opposite side of the trade. Just like trading an individual stock. The price you buy or sell a mutual fund is determined at the end of the day and by the “net asset value” of that share.
ETF's may hold hundreds or thousands of securities in a particular asset, such as stocks, bonds, currencies, metals, futures, and other strange animals. Much like a closed-end mutual fund, there is a set number of shares that trade, where each share represents a small fraction of the total assets in that fund. However unlike a closed-end fund, new shares are created as needed. Problems insue whenever a fund sponsor is unable to create new shares. When this happens, the ETF shares act more like a closed-end fund, and could deviate from the index they intend to track.
This Forbes article, The Godfather of ETFs describes in good detail how a market maker in ETFs operates. The three largest RTF trading firms are Goldman, Merrill Lynch and Knight Capital.
The market is large. According to the Blackrock's quarterly review of all exchange traded products, titled ETP Landscape – Industry Highlights – Q3 2012, total assets under management for all exchange traded products are in excess of 1.84 trillion dollars, spread over 4748 funds. The Forbes article pegged the assets under management for traditional mutual funds at over 10 trillion dollars.
| AssetType | Assets($Billions) | NumFunds | |
|---|---|---|---|
| 1 | Equity | 1290.2 | 2597 |
| 2 | FixedIncome | 321.4 | 618 |
| 3 | Commodities | 206.7 | 906 |
| 4 | Alternative | 6.8 | 124 |
| 5 | Currency | 5.7 | 139 |
| 6 | Other | 14.7 | 364 |
Largest ETF providers
The four largest fund providers by total assets under management are (ibid):
| Name | Assets($Billions) | Market Share(% | |
|---|---|---|---|
| 1 | iShares | 711.8 | 38.6 |
| 2 | State Street Global Advisors | 333.4 | 18.1 |
| 3 | Vanguard | 230.8 | 12.5 |
| 4 | Powershares | 76.4 | 4.1 |
What investments are in an ETF
Stocks Initially, ETFs replicated major indexes such as the S&P500. For instance, the State Street SPDR S&P500 is the largest of all ETFs at $118 Billion. There are ETFs that track almost any of the major known indexes. There are ETFs for sectors of the stock market (eg. Technology, Health, Utilities, etc…); style and size indexes (eg. Value, Growth, Small cap, Large Cap, etc…); international stock markets, (by region, by by country, by sectors, and combinations). These are meant to be passive in that the index is specified up front, and the investment manager attempts to adhere as close as possible to that index. Active investment management by the portfolio manager is new feature only recently made available in some ETFs. In this case, the portfolio manager has some leeway to make individual investment decisions.
Bonds Similarly, ETFs focused on bonds may be focused on tracking various indexes based duration (short-term 0-3 years, mid-term bonds 5-10 years, long-term over 10 years), source (governemt, corporate), country (US, or otherwise).
Commodities Usually, these are structured as Exchange Traded Notes, and use futures contracts to track an index. I'll say more about these at a later time. A few do hold physical metals, such as the State Street Gold ETF (GLD), which is actually structured as a trust.
REITs Real-estate investment trusts are securities that are committed to pass along 90% of their income as dividends to the share holder. REIT based ETFs hold shares in these companies.
Other There are ETFs for currencies, short equities, leveraged equities, short leveraged equities, volatility, and many other flavors of indexing.
Resources
Additional sources of information on ETF's. The general information websites all have varying degrees of free information and premium services. I usually go straight to the fund family websites, but probably should spend more time reading the reports and news items from the general sites.
General information sites
- Morningstar If your local library has a subscription, see if you can't possibly access Morningstar through the library's web site.
- SmartMoney Some free, some premium services.
- ETF Trends has many educational articles, and an ETF screener.
- ETFdb has more news and screeners.
Fund Family websites
Mostly Quantitative 