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ETF Investing

Exchange Traded Funds

What Is An Exchange Traded Fund?

Exchange traded products are derivatives of underlying assets which trade on a national stock exchange as an intra day security. An exchange traded fund is a type of exchange traded product.

Exchange traded funds, also known as the ETF, is a securities vehicle which holds groups of related assets, but trades on the securities market. The underlying assets of an ETF may include bonds, commodities, or stocks, and its price tends to follow approximately the same price as the NAV, or net asset value, of the underlying held assets. Some of the most popular exchange traded funds also follow the price of a large index, like the Dow Jones Industrial Average or the S&P 500.

Of all exchange traded products, exchange traded funds are the most popular.

How Is An Exchange Traded Fund Actually Traded?

The only investors who directly purchase an exchange traded fund are large, institutional investors known as authorized participants. These investors will purchase large amounts of an exchange traded fund along with shares of the underlying securities. They will then use their ability to trade out the exchange traded fund shares for shares of the underlying securities to act as market makers, and profit by selling the ETFs to retail investors on what is known as the secondary, or retail, market.

History of the Exchange Traded Fund

The idea of the exchange traded fund was first implemented in Canada, when Toronto Index Participation Shares began selling in 1990 on the Toronto Stock Exchange. The popularity of the product caught the attention of American stock exchanges, who began work on a product that would pass the then quite stringent SEC regulations.

In 1993, the Spider was born of the ideas of Steven Bloom and Nathan Most, who were then executives on the American Stock Exchange. Known also as SPDRs, the acroynm stood for Standard & Poor's Depositary Receipts, and entered the market in January. Many others followed suit, and today the exchange traded fund format is responsible for $882 billion worth of assets spread among 916 securities.

Uses of the Exchange Traded Fund

The exchange traded fund format has proved continually popular because of their instant diversification, tax incentives, and low expense ratios. Also, the easy trading nature of the exchange traded fund make them a favorite of day traders and short term investors.

Because the exchange traded fund is not actively managed or marketed, their cost is much lower. Because of this, and their ability to be traded intraday, the exchange traded fund is used in a number of hedging strategies. They can also be easily automated by retail trading applications with the use of stop and limit orders, further increasing their flexibility.

The exchange traded fund can be bought and sold short, which allows investors to get around many of the SEC induced monetary limitations for short selling securities.

Some funds may also invest in derivatives of securities as well as the securities themselves, giving the exchange traded fund an especially strong movement for a small movement in the underlying assets. These funds are known as leveraged funds, and may attempt to follow twice or three times the performance of the underlying asset basket.


Exchange Traded Fund Types

The index exchange traded fund is a fund which attempts to follow the movement of a stock market index.
The commodity exchange traded fund invests in commodities, such as silver, or gold.
Bond ETFs invest in bonds.
Currency ETFs invest in currencies across the world.

Criticism of the Exchange Traded Fund

Opponents of the exchange traded fund argue that ETFs do not provide enough diversification for the average investor. Also, the flexible nature of the exchange traded fund tends to attract short term speculation rather than true investment. Also, because they are subject to the whims of the market, ETFs do not always succeed in tracking their underlying asset basket.

 

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