Understanding Exchange-Traded Funds: How ETFs Work

Key Findings

An exchange-traded fund (ETF) is a pooled investment vehicle with shares that can be bought or sold throughout the day on a stock exchange at a market-determined price. Like a mutual fund, an ETF offers investors a proportionate share in a pool of stocks, bonds, and other assets.
Demand for ETFs has grown markedly in the United States. From year-end 2003 to June 2014, total net assets have increased twelvefold, from $151 billion to $1.8 trillion, and the number of ETFs has increased from 119 to 1,364.
Specific features of ETFs that investors find attractive, as well as general trends in investing and money management, have contributed to the growing popularity of ETFs. These features include intraday tradability, transparency, tax efficiency, and access to specific markets or asset classes. ETFs also have gained favor due to the rising popularity of passive investments, increasing use of asset allocation models, and a move toward external fee-based models of compensation.
The vast majority of ETFs are registered as investment companies under the Investment Company Act of 1940 (Investment Company Act) and are regulated by the Securities and Exchange Commission. These ETFs are subject to the same regulatory requirements as other registered funds; however, they must first receive exemptive relief from certain provisions of the Investment Company Act before they can commence operations.
Generally, the price at which an ETF trades on a stock exchange is a close approximation to the market value of the underlying securities that it holds in its portfolio. Two primary features of an ETF’s structure promote this fairly tight relationship: transparency and the ability for authorized participants (APs)—typically large financial institutions—to create or redeem ETF shares at net asset value at the end of each trading day.
Creations and redemptions of ETF shares have safeguards that protect an ETF and its shareholders from a default by an AP. Creations and redemptions processed through the National Securities Clearing Corporation (NSCC) have the same guarantee as a domestic stock trade. For ETF shares created and redeemed outside NSCC’s system, ETFs usually require APs to post collateral.
On most trading days, the vast majority of ETFs do not have any primary market activity—that is, they do not create or redeem shares. Instead, when accessing liquidity in ETFs, investors make greater use of the secondary market (trading shares) than the primary market (creations and redemptions transacted through an AP). On average, daily aggregate ETF creations and redemptions are a fraction (10 percent) of their total primary market activity and secondary market trading, and account for less than 0.5 percent of the funds’ total net assets.
On average, daily creations and redemptions are a greater proportion (19 percent) of total trading for bond ETFs than for equity ETFs (9 percent). Because bond ETFs are a growing segment of the ETF industry, many small bond ETFs tend to have less-established secondary markets. As more bond ETFs increase their assets under management, the secondary market for these products is likely to deepen naturally.
Despite proportionately higher primary market activity for bond ETFs, the impact on their underlying portfolios fromcreations and redemptions has been limited. Average daily creations and redemptions of bond ETFs were 0.34 percent of total net assets.

Understanding Exchange-Traded Funds: How ETFs Work – Introduction

The Growing Success of ETFs

Exchange-traded funds (ETFs) have been one of the most successful financial innovations in recent years. Since the introduction of ETFs in the early 1990s, demand for these funds has grown markedly in the United States, as both institutional and retail investors increasingly have found their features appealing. In the past decade alone, total net assets of ETFs have increased twelvefold, from $151 billion at year-end 2003 to $1.8 trillion as of June 2014 (Figure 1).

With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives. As of June 2014, there were 1,364 U.S.-registered ETFs, up from 119 at year-end 2003. Like mutual funds, ETFs are a way for investors to participate in the stock, bond, and commodity markets; achieve a diversified portfolio; and gain access to a broad array of investment strategies. Although total assets managed by stock, bond, and hybrid mutual funds are significantly larger ($13.1 trillion) than those of ETFs ($1.8 trillion), ETFs’ share of their combined assets has increased considerably—from less than 3 percent at year-end 2003 to a little more than 12 percent by June 2014.

Several factors have contributed to the growing popularity of ETFs. Some of these factors are related to specific features of ETFs that investors find attractive, while others correspond to more recent general trends in investing and money management.

Specific features of ETFs that investors find attractive include:

Intraday tradability. An ETF is essentially a mutual fund that has a secondary market.2 This means that investors buy or sell existing ETF shares at market-determined prices during trading hours on stock exchanges, in dark pools, or on other trading venues. This feature gives investors liquidity and quick access to different types of asset classes. Initially, ETFs were used primarily by institutional asset managers to “equitize” cash (i.e., turn cash holdings into an equity position while maintaining liquidity), thus reducing the drag on portfolio returns that usually accompanies cash positions.
More institutional asset managers also have found ETFs to be a convenient tool to hedge against broad movements in the stock market and as a temporary parking place when rebalancing their portfolios or transitioning management of the fund from one manager to another.

Price transparency. Generally, the price at which an ETF trades in the secondary market is a close approximation to the market value of the underlying securities held in its portfolio. This fairly tight relationship makes ETFs a convenient and easy option for investors who want to minimize the possibility that the share price could trade at a substantial premium or discount to the net asset value (NAV) of the fund (as can happen in a closed-end fund).

Tax efficiency. Investors have been attracted to ETFs as typically only a small percentage have distributed capital gains. Since most ETFs track an index, they have lower portfolio turnover than actively managed funds and fewer realizations of capital gains. Also, ETFs more frequently use in-kind redemptions to reduce their unrealized gains (also known as tax overhang) by distributing securities that were purchased for less than their current value (commonly referred to as low-basis securities). Because these transactions are in-kind, the ETF does not incur any tax when the low-basis securities are redeemed. As a result, many ETF investors do not incur capital gains taxes until they sell their ETF shares.