Exchange-traded funds (ETFs) are pooled investment vehicles that have experienced significant growth since 2000. In this primer from SIFMA Insights, we provide a fundamental overview of ETFs, including:

• Defining Exchange-Traded Funds
• ETF Versus Other Investment Products
• ETF Legal Structures
• ETF Regulation
• Global ETP and US ETF Landscapes
• Growth in the US ETF Market
• ETF Creation/Redemption Process
• Secondary Market Volumes
• Market Share Overview

Executive Summary

Exchange-traded funds (ETFs) are pooled investment vehicles holding an underlying basket of securities, whether it be equities, bonds, commodities, currencies or hybrids. They trade intraday on exchanges and other trading venues (similar to single stocks) and are priced based on market demand for their shares, typically driven by the underlying securities’ prices(1). ETFs can be broken out by asset class, region, investment style, or a number of other classifications, providing investors a multitude of choices to meet many different investment objectives.

ETFs differ from mutual funds (MFs) in a variety of ways, in particular increased price transparency and intraday liquidity(2) from being traded on exchanges. ETFs may also provide greater tax efficiencies and, in general, lower total expense ratios (albeit this can vary by fund), compared to MFs with similar investment strategies. Morningstar estimates ETFs cost one-third the price of an average MF and carry one-half of the tax expense of the average actively managed MF (as of FY17; this can vary by fund). In light of their general cost efficiency, ETFs have shown strong demand from individual and institutional investors, both of which are cost sensitive. Although most ETFs are structured similarly, they can come in varying legal structures which can impact capital distributions (dividends) and have tax implications. While there has always been individual investor appeal, ETF usage by institutional investors in portfolio management strategies continues to grow as well.

U.S. domiciled ETFs have seen significant growth since 2000, growing at a 24.5% CAGR for the total market to $3.4 trillion as of FY17. Yet, the U.S. domiciled ETF market is still small compared to other U.S. markets – fixed income markets are 11.6x greater then ETFs; equities are 9.4x ETFs; and MFs are 5.5x ETFs. A truer parallel can be drawn between investment products, ETF and MFs, as well as to the growth experienced in the development of the MF industry. Since 2000, ETFs grew at a 25% CAGR, versus 6% for MFs.
What makes ETFs unique is the creation/redemption process, which increases or decreases the number of ETF shares available to the market, based on investor demand. As detailed in this report, authorized participants (APs deliver a specified basket of underlying securities (creation basket; APs may also provide cash) to the ETF – the primary market. The ETF will then provide the AP with a fixed amount of ETF shares (creation units; large blocks of shares, typically ranging from 25,000 to 200,000), increasing the supply of ETF shares in the market. (The reverse is done by buying back a redemption basket from the ETF, which then takes back creation units to decrease the supply of ETF shares in the market.) APs can sell all or part (they may hold some for their own inventory) of the
creation units on exchanges and other trading venues – the secondary market. Responding to supply and demand imbalances in the market – when the price of an ETF share does not equal the price of the underlying securities – APs add to (or reduce) the number of ETF shares available. This arbitrage process keeps the ETF share price close to net asset value, which is primarily determined by the market prices of the securities held in the ETF’s portfolio, and meets market liquidity needs.

(1) Throughout this report, we use the terminology underlying securities to include a broad category of potential assets, such as: stocks, bonds, commodities and other investments.

(2) Liquidity is defined as ease with which an asset (ETF shares, MF shares or single stocks) can be quickly and efficiently bought or sold in the market without significantly affecting its price.

SIFMA Insights Primers

The primer series from SIFMA Insights goes beyond a typical 101-level brief, breaking down important technical and regulatory nuances to foster a fundamental understanding of the marketplace and set the scene to address complex issues arising in today’s markets.

See our full series here.

Authors

SIFMA Insights

Katie Kolchin, CFA
Senior Industry Analyst

Asset Management Group

Timothy W. Cameron, Esq.
Managing Director, Head of Asset Management Group

Equities

T.R. Lazo
Managing Director, Associate General Counsel