Exchange Traded Funds

An Exchange Traded Fund is a relatively new type of investment vehicle that acts like a cross between a mutual fund and a listed share. When you buy an ETF, you buy into a diversified basket of stocks, but you do so through a single security. As such, you can buy on margin, trade intra-day, sell short, and do all of the other things that you can do with listed shares.

ETFs are invariably based on index funds, which are a particular type of mutual fund, so to fully understand ETFs it is necessary to take a slight diversion.

The object of any mutual fund is to obtain a return for its investors. Equity fund managers look to beat the return of a benchmark index, such as the S&P 500. But many fund managers fail the test, despite employing high-powered analysts in the effort. These high-powered analysts can be expensive. Some time ago, the thought occurred to people in the industry that the analysts might be sacked and instead a fund manager might invest directly in the constituent stocks of a benchmark like the S&P 500. Such a fund could never beat the S&P 500, but on the flipside it could never be beaten. In addition, it could offer investors the attraction of significantly lower fees. Thus, index funds were born.

Exchange Traded Funds are index funds re-shaped so as to be able to trade as shares on an exchange. The sleight-of-hand that effects this transformation is rather complex, but here are the basics: Exchange Traded Funds are created in a primary market by large institutions and then broken up into shares that trade in a secondary market (on an exchange) where you and I can trade them.

You might ask how an ETF can accurately track an index when the listed shares are subject to the vagaries of supply and demand. The answer is “arbitrage”. Institutions can swap back and forth between the primary market and the secondary market when exploitable discrepancies in pricing arise. Arbitrage keeps the prices in line, although its fair to say that ETF arbitrage has never really been tested in a wild 1987-type of crash.

The history of ETFs dates back to 1993, when AMEX listed the “Spiders” – S&P Depositary Receipts, Trust Series 1. AMEX has been at the forefront of the ETF industry. Other well-known ETFs with strange nicknames include the Diamonds and the Cubes. The leading ETFs and the particular index they track are summarised in the table below.

ETFs are powerful and versatile investment vehicles. From modest beginnings, when they simply tracked major indices, ETFs are now being developed to track specific market sectors, regions and even discretionary funds. ETFs reached Australia n March 2001 when Salomon Smith Barney launched its Index Shares 100 product (ASX code IDX). In August 2001, State Street Global joined the fray with the Street Tracks 200 and Street Tracks 50 (ASX codes STW and SFY). If the overseas experience is anything to go by, these first products represent merely the tip of the iceberg.

Useful Links

SPDRs ASX ETFs

iShares ETFs

AMEX ETFs

NYSE ETFs

NASDAQ ETFs

ETFs Central

ETF Statistics

ETF Glossary