An exchange traded fund (ETF) is a basket of securities that trades on an exchange which provides individuals access to an investment strategy. ETFs may be invested in stocks, bonds, commodities, derivatives, or combinations thereof. They may also provide exposure to an asset class, market sector or subsector, or theme.

ETFs have been available as an investment product for nearly 30 years in the United States. The first ETF — a broad-based domestic equity fund tracking the S&P 500 index — was introduced in 1993 after a fund sponsor received US Securities and Exchange Commission (SEC) exemptive relief from various provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. Until 2008, SEC exemptive relief was granted only to ETFs that tracked designated indexes. These ETFs, commonly referred to as index-based ETFs, are designed to track the performance of their specified indexes or, in some cases, a multiple of or an inverse (or multiple inverse) of their indexes.

In early 2008, the SEC granted exemptive relief to several fund sponsors to offer fully transparent actively managed ETFs that meet certain requirements. Among other requirements, these actively managed ETFs must disclose each business day on their publicly available websites the identities and weightings of the component securities and other assets held by the ETF. Actively managed ETFs do not seek to track the return of a particular index. Instead, the investment adviser of an actively managed ETF, like that of an actively managed mutual fund, creates a unique mix of investments to meet a particular investment objective and policy.

An ETF originates with a sponsor, who chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways. A replicate index-based ETF holds every security in the target index because it invests 100 percent of its assets proportionately in all the securities in the target index. A sample index-based ETF does not hold every security in the target index; instead the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for ETFs that track indexes containing securities that are too numerous (such as broad-based or total stock market indexes), that have restrictions on ownership or transferability (certain foreign securities), or that are difficult to obtain (some fixed-income securities).

Most ETFs are registered with the SEC as investment companies under the Investment Company Act of 1940, and the shares they offer to the public are registered under the Securities Act of 1933.

The ETF structure may allow for certain benefits and efficiencies for investors when compared with other product structures. Operational efficiencies, costs, and tax benefits are just some of these.

• Tax Benefits – Since shares are not sold in the ETF to facilitate outflows, there are no taxable gains realized in the fund which are ultimately distributed to the remaining fund holders. In addition, the ETF may choose to deliver low-cost shares of the underlying securities, thus potentially eliminating future capital gains within the fund.
• Ease of Implementation – Implementing the investment strategy is achieved through one trade – purchasing the ETF – rather than having to purchase all of the underlying securities. This eliminates the need to trade across multiple fund families. All rebalancings are executed at the ETF level. Therefore, the advisor does not need to trade every time the portfolio is rebalanced.
• Diversification/Liquidity – ETFs may offer the ability to invest in less liquid securities and asset types. It may be difficult to purchase asset classes that are less liquid and have a small allocation in an investment model for accounts with lower asset levels. Within an ETF, all investors, regardless of asset size, gain access to the identical strategy. ETFs may allow access to less liquid securities such as high-yield bonds, alternatives, etc., that would not be available to individual investors.
• Ability to market your strategy to a wider audience – Since the ETF is trading on an exchange, anyone with a brokerage account may be able to purchase shares.
• Cost – ETFs often have lower expense ratios than other product structures.

ETF shares are created when an “authorized participant”—typically an institutional investor—deposits the daily creation basket or cash with the ETF. In return for the creation basket or cash (or both), the ETF issues to the authorized participant a “creation unit” that consists of a specified number of ETF shares. Creation units are large blocks of shares that generally range in size from 25,000 to 200,000 shares. The authorized participant can either keep the ETF shares that make up the creation unit or sell all or part of them on a stock exchange. ETF shares are listed on a number of stock exchanges where investors can purchase them as they would shares of a publicly traded company.

ETFs may allow advisors to more efficiently allocate their client’s funds to a wider range of investment options, including some that are less liquid or those that have smaller allocations within the strategy.

Among the many potential benefits of the ETF structure, the one most often cited is their tax efficiency. As a whole, ETFs generally distribute fewer capital gains to their holders than mutual funds. Additionally, ETFs may afford shareholders the ability to time if and when they realize potential tax implications associated with their investment.

ETFs aren't necessarily more tax-efficient. The ETF construct of indexing allows for lower turnover, which can result in lower capital gains distributions.

The value of an ETF is determined by the prices of the underlying securities. This is called the Net Asset Value (NAV). The market price should be similar to the NAV and is affected by the supply and demand of the ETF. When the price of an ETF is trading above its NAV, it is said to be trading at a premium, and when the price of an ETF is trading below its NAV, it is said to be trading at a discount.

The process through which the AP creates or redeems ETF shares. In a creation, the AP delivers a basket of stocks representing the holdings of an ETF and receives shares of the ETF. In a redemption, the AP delivers the shares of the ETF and receives a basket of stocks representing the holdings of the ETF.

ETFs may be an attractive investment vehicle for advisors with a large base of SMA assets. They may offer significant tax benefits, ease of implementation, diversification and liquidity, the ability to market your strategy to a wider investment base, and lower costs.

One of the benefits of ETFs is the ability to provide exposure to multiple securities within one product. ETFs can be used to diversify and complement any portfolio as our products provide exposure to a variety of sectors and geographic regions.

Yes. ETC has worked with RIAs to convert hedge funds into ETFs. We pride ourselves on taking the time to conduct deep and thorough due diligence in order to build a strategy, product, and structure that will serve as the foundation for growth for your ETF.

Sponsors must be willing to register with the SEC as a sub-advisor, or if an index provider, establish a robust compliance program subject to board approval. While anyone can start an ETF, we conduct deep and thorough due diligence in order to build a strategy, product, and structure that will serve as the foundation for growth for your ETF.

Socially Responsible ETFs incorporate environmental, social, and corporate governance considerations into their investment approach.

A Prospectus is a formal document that is required by and filed with the Securities and Exchange Commission (SEC) that provides details about an investment offering to the public.

The performance of a fund that exceeds the benchmark’s performance.

AUM is the total market value of the investments that a person or entity handles on behalf of investors.

The total amount of fees paid by the investors of an ETF divided by the total assets. It is used as a metric to quantify the cost of investing in the ETF.

Commonly referred to as the “AP.” The AP facilitates the ETF creation/redemption process. The AP is the only market participant who can create or redeem shares of ETFs.

The correlation of a portfolio to its benchmark or the percentage of the portfolio’s return that can be explained by the benchmark’s return.

The bid (ask) price at which an individual can sell (buy) a security. The spread is the difference between the two prices.

The number of share required to either create or redeem ETF shares.

The Investment Company Act of 1940 (commonly referred to as the '40 Act) is an act of Congress that regulates investment funds. It is enforced and regulated by the Securities and Exchange Commission (SEC).

The ability to buy or sell a security in the market without causing a drastic change in the asset’s price.

A firm that stands ready to buy and sell securities on a regular and continuous basis at a publicly quoted price. Market makers provide liquidity in ETFs.

Commonly referred to as the NAV. It is the total value of the holdings of the ETFs divided by the number of ETFs shares.

The difference between the performance of an ETF and that of its benchmark.

A passive ETF is a vehicle that seeks to replicate the performance of the broad equity market or a segment of it by tracking custom indices.

A basket of securities in which the portfolio manager actively makes investment decisions that are not based on the composition of an index.

A basket of securities that is designed to replicate the performance of a market index.

An ETF structure which does not require daily disclosure of the holdings of the ETF.

ETFs which look to capture common investment factors, such as value, momentum, and quality.