by Tyler Curtis
After announcing the SIM-ETF portfolio we fielded a lot of phone calls from interested clients asking us to further explain exactly what ETF’s are. With over 1,400 exchange traded products on the market, it is not surprising that we regularly get this question, and as we have written before, not all ETFs are created equal.
The simplified definition of an ETF is: An exchange-traded fund, or ETF, is an investment product representing a basket of securities that track an index such as the Standard & Poor’s 500 Index. ETFs, which are available to individual investors only through brokers and advisors, trade like stocks on an exchange.
For a more in depth look at what constitutes an ETF we have to walk through the creation process. The creation of an ETF begins when a prospective ETF manager files a plan outlying the objectives of the ETF with the SEC to create an ETF. Once this plan receives approval, the manager forms an agreement with an authorized participant, in most cases this is a market maker, specialist or large institutional investor, who is authorized to create or redeem the ETF’s shares.
This authorized participant then borrows shares of stock in accordance with the ETF manager’s prospectus, places those shares in a trust, and uses them to form creation units of the ETF. Creation units are bundles of stock varying in size, typically 50,000 shares is designated as one creation unit of a given ETF. The trust then provides shares of the ETF to the authorized participant; these shares are legal claims on the shares held in the trust. Essentially ETF shares represent tinny livers of the creation units. Because this transaction is in-kind (securities traded for securities) there are no tax implications. Once the ETF shares are received by the authorized agent they are sold to the public on the open market just like shares of stock.
When an ETF share is bought or sold on the open market the underlying securities remain in the trust account. The trust generally has little activity beyond distributing dividends from the stocks held to the ETF owners and providing administrative oversight. As interest in the ETF grows more creation units are generated and additional shares are issued. Creation units are not impacted by the transactions that take place when ETF shares are bought or sold on the open market.
For those of us that are more visual learners mint.com has created a comprehensive infographic that goes into great detail on what an ETF is and the pro’s and con’s associated with them.
(Click image to view larger)