How ETFs work!

A lot of people, when they first find out about Exchange Traded Funds (ETFs), are amazed that they haven't heard of them before. They quickly identify the key benefits; Low Cost, Transparancy and Broad Diversification being very attractive items in an investment pool.

In this blog I am happy to answer general questions on how ETFs work and invite anyone in the public to ask questions.To kick off this blog I will go through some of the fundamental aspects of traditional ETFs then we can explore specific questions as they come through.

Exchange Traded Funds according to Wikpedia : An exchange-traded fund (or ETF) is an investment vehicle traded on stock and commodity exchanges, much like stocks or contracts. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.

In Australia the common index is the S&P/ASX 200 (STW), S&P/ASX Listed Property (A-REIT) (SLF) there is a wide range of ETFs now traded on the ASX covering more local and international indicies plus commodity ETFs. All the ETFs are issued with a Product Disclosure Statement and all are managed by world leading firms. Several smaller boutique managers have entered the Australian market increasing the selection of ETFs available on the ASX. Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of the underlying ETF directly from/to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. These institutional investors then offer these ETF units like shares on the secondary market for the public and fill supply and demand via the ASX.

Authorized participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with the underlying securities to provide liquidity ot the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets.

Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market. An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value.

Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. This is usually due to the fact that the managers of these securities will hold them in a Corporate Structure called a Listed Investment Company or LIC rather then as an open ended trust like the ETF. This is a key difference between the two structures as the ETFs can constantly create new units to fill demand where as the LIC's have a limited number of shares on issue which can affect the LIC's ability to trade close to NAV.

ETFs have been available in the US since 1993 and in Europe since 1999. [and in Australia since 2001] ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.

In Australia all the current ETFs are index funds with the ETC's Exchange Traded Commodities being preference shares with direct link to a commodity such as Gold.