Exchange-traded fund

Exchange-traded fund (ETF) is an investment fund whose shares are traded on a stock exchange in the same manner as individual stocks. An exchange-traded fund typically holds a portfolio of assets, such as equities, bonds, commodities, currencies, or other financial instruments, and seeks to track the performance of a specified stock market index, bond market index, commodity index, sector, investment strategy, or actively managed portfolio. ETFs combine features of both mutual funds and publicly traded securities by offering diversified investment portfolios that can be bought and sold throughout the trading day at market prices. Since their introduction in the early 1990s, ETFs have become one of the most widely used investment vehicles among retail and institutional investors.

History

The concept of exchange-traded funds emerged during the late twentieth century as financial institutions sought investment products combining the diversification of mutual funds with the continuous trading characteristics of listed securities.

The first widely successful ETF, the SPDR S&P 500 ETF Trust (SPY), was launched in the United States in 1993 to track the S&P 500. The product demonstrated the feasibility of intraday trading for diversified investment portfolios and contributed to the rapid growth of the ETF industry.

During the following decades, ETFs expanded beyond broad equity indices to include fixed-income securities, commodities, international markets, sectors, currencies, factor-based strategies, and actively managed portfolios. Today, ETFs are listed on stock exchanges throughout the world and represent a significant segment of global investment assets.

Structure

An exchange-traded fund is generally organized as an investment fund that holds a portfolio of underlying assets.

Depending on its investment objective, an ETF may invest in:

stocks;
bonds;
commodities;
currencies;
money market instruments;
real estate investment trusts (REITs);
derivatives;
other investment funds.

Shares of the ETF are listed on one or more stock exchanges and may be traded throughout the trading day.

Investment strategies

ETFs employ a variety of investment strategies.

Common categories include:

index-tracking ETFs;
actively managed ETFs;
sector ETFs;
industry ETFs;
bond ETFs;
commodity ETFs;
international ETFs;
thematic ETFs;
environmental, social and governance (ESG) ETFs;
leveraged ETFs;
inverse ETFs.

Many ETFs are designed to replicate the performance of a benchmark index, while others pursue actively managed investment strategies.

Creation and redemption

Unlike traditional mutual funds, ETFs employ a creation and redemption mechanism involving authorized participants.

Under this process:

authorized participants deliver a basket of underlying securities to the ETF issuer in exchange for newly created ETF shares; or
ETF shares are returned to the issuer in exchange for the underlying securities.

This mechanism helps align the ETF's market price with the net asset value (NAV) of its underlying portfolio.

Trading

ETF shares are traded on stock exchanges in the same manner as common stocks.

Investors may:

buy or sell ETF shares throughout the trading day;
place market, limit, or stop orders;
trade on margin, where permitted;
sell shares short, subject to applicable regulations.

The market price of an ETF may differ slightly from its net asset value because of market supply and demand, although the creation and redemption process generally helps reduce significant price discrepancies.

Advantages

Exchange-traded funds have several characteristics that have contributed to their widespread adoption.

These include:

portfolio diversification;
intraday trading;
relatively low management fees;
transparency of holdings for many index-based ETFs;
flexibility in portfolio construction;
broad market access;
relatively low portfolio turnover for index-tracking ETFs.

ETFs also enable investors to gain exposure to specific sectors, geographic regions, asset classes, or investment strategies through a single security.

Limitations

Despite their popularity, ETFs have several limitations.

Common considerations include:

exposure to market risk;
tracking error relative to benchmark indices;
bid–ask spreads;
brokerage commissions, where applicable;
liquidity differences among ETFs;
additional risks associated with leveraged or inverse ETFs.

Certain specialized ETFs investing in less liquid assets may experience wider price deviations from their underlying net asset values.

Relationship with index funds

Many ETFs are index funds because they seek to replicate the performance of a benchmark index through passive investment.

However, not all ETFs are index funds. Some ETFs are actively managed and do not track a benchmark index. Similarly, many index funds are structured as traditional mutual funds rather than exchange-traded funds.

The distinction therefore relates to both the investment strategy and the legal structure of the fund.

Regulation

Exchange-traded funds are regulated under the securities laws of the jurisdictions in which they are established and listed.

Regulatory oversight is generally provided by securities regulators responsible for:

fund registration;
disclosure requirements;
investor protection;
market conduct;
listing standards.

ETF issuers are also subject to the listing requirements of the stock exchanges on which their shares are traded.

Impact

Exchange-traded funds have transformed global investment management by providing investors with low-cost, diversified, and readily tradable investment vehicles. Their growth has supported the expansion of passive investing and increased access to domestic and international financial markets for both institutional and retail investors. ETFs are widely used for asset allocation, portfolio diversification, risk management, retirement investing, and tactical investment strategies, and they have become one of the principal investment products in global capital markets.