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
||NASDAQ 100 Index Tracking Stock
||S&P Depositary Receipts, Trust Series 1
||DIAMONDS Trust Series 1
|| S&P 500
||Dow Jones Industrial Average
|Price relationship to index
||March 10, 1999
||Jan. 29, 1993
||Jan. 20, 1998
Average Daily Volume
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.
||Street Tracks 200
||Street Tracks 50
||Index Shares 100
||S&P ASX 100
|Price Relationship to Index
||August 27, 2001
||August 27, 2001
||March 2, 2001
|Average Daily Volume
SPDRs ASX ETFs