Exchange Traded Funds


An exchange-traded fund (ETF) is an investment company, set up either as an open-end company or a unit investment trust (UIT). It has shares (underlain by a basket of securities) that trade intraday on a stock exchange at prices determined in the market. It will further be realized that  exchange traded funds (ETFs) are extraordinary new investments, each one across between a mutual fund and a stock. They function like mutual funds but trade like stocks. This article will explain how exchange traded funds work, how they are used, and why they should indeed be used. ETF work better for long-term investing even better, in fact, more than mutual funds. The article will provide a detailed account of exchange-traded funds (ETFs), covering how they work, their distinctive characteristics, who trades in them, who owns them, and their advantages and disadvantages. The discussion presented below will also focus both on the features of exchange traded funds that are basically provided by mutual fund industry as well as their influence to the investment sector. The discussion will entail the exchange traded funds features in the expanding product mix that is provided for by mutual fund industry and how its influence the investment sector.Re-phrase. Not clear what you mean to say here.  ETFs are considered part of the emerging trend towards the segmentation of the market place of mutual funds with those investors wishing to frequently trade; it is segregated into several products as opposed to favoring the low income investors. Exchangetraded funds can only attract those investors that value their ability to frequently trade; this will reduce the rate of turnover for those investors who will continue to invest in the traditional open end equity funds (Hehn, 2005). In general, this article sets to prove  whether exchange traded funds are actually the emerging preferable investment tools for frequent traders or everyone including traditional investors. .

History of Exchange-traded Funds

Exchange traded funds are investment funds that are traded on stock exchange markets in the manner stocks are. Exchange traded funds holds assets  that extend to include  bonds, commodities and stocks. They trade close to the Net Asset Value (NAV) of the period of the trading day. Most exchange traded funds track index such as bond index and stock index. This may be attractive as a form of investment due to the low costs involved, tax efficiency and features like those of stocks. It will be documented that exchange traded funds have low tax rates that are attached to them unlike other investment funds making them to be seemingly cheap and attractive to various investors. How is it low cost, tax efficient? Explain. Exchange traded funds are considered the most popular form of exchange traded products (Wild, 2011).The first exchangetraded fund came into being on January 29, 1993. It was called Standard & Poor’s Depositary Receipts (Richards, 2007). Since then ETRs have grown at a high rate as shown in the graph below.

Figure 1(BlackRock, 2013)

It is only those participants  that are authorized are in a position   to deal with large broker deals; they should have entered into agreement with ETF distributors or when they purchase or sell ETF shares directly to or from the funds; this is only in creation units including thousands of exchange traded shares. These shares are exchanged in kind with securities baskets (Hehn, 2005).

Participants that are authorized may need to invest in ETF shares for a long term period. These participants act as market makers in the open market by using the ability to create units with underlying securities to offer ETF liquidity and ensure that the intra day market marches the value of their underlying assets. There are other individual investors who act as retail broker and trade in exchange traded shares in the secondary market (Hehn, 2005).

Exchange traded funds combine valuation features of unit investment trust and mutual funds that can be purchased or sold at the close of each business day for the net asset value, with the tradable feature of the closed end funds that trades throughout the business day at prices that may be above or below the net asset value.  The closed ended funds are not treated as exchange traded funds, although they are traded on exchange like other securities.  This type of funds have been traded in USA since 1993 and in Europe, it was traded from 1999. Exchange traded funds have traditionally been traded as index funds. In 2008, the US Securities and Exchange Commission started authorizing the creation of exchange traded funds that are actively managed (Hehn, 2005).

All ETF shares are held electronically in brokerage accounts.  This is one of the reasons why exchange-traded funds are inexpensive for investors. The regulatory burden on unit investment trusts is lower than on open-end mutual funds. To cut costs, the first few exchange-traded funds were organized as UITs. Unit investment trust is an investment company that issues redeemable units or securities which implies that it can purchase back the investors’ units only at the consent of the investor. It will thus be realized that ETFs are truly structured just like the UITs.

which are?. But after ETFs proved to be popular, most subsequent ETFs were organized as open-end mutual funds. As an ETF shareholder, you cast your vote on the proxies that are sent to you by the trustee’s board of directors. But you do not vote the proxies of the companies whose shares are owned by the fund. These are voted under the direction of the ETF board (Wiandt, & McClatchy, 2001).

Types of Exchange Traded Funds

Exchange-traded funds are currently growing at an alarming rate as shown on the graph.. Isn’t it way more than this based on your graph above?The American Stock Exchange was the first to trade them, and it remains the secondary marketplace for the majority of ETFs. But, sensing rich plums, other exchanges are getting into the act. On July 31, 2001 the New York Stock Exchange began trading (Hehn, 2005).

The ETFs are divided into four categories, as follows:

1.  No fundamental ETFs. Unless the description identifies the fund as weighted equally, assume that it’s weighted by capitalization. Diamonds are the only price-weighted fund.

2.  Fundamental ETFs. The stocks are weighted according to the degree to which they meet the fundamental standards  such as stock price, dividend yield, return on equity, earnings yield among others.Which are?

3. Short sellers.

4. Commodities and foreign currencies.

Fundamental ETFs are bound to trade more frequently, for example in case the fund tracks an index based on dividend levels. Assume that one of the companies in the index doubles its dividend. The “dividend weight” of that company has increased. The fund manager must therefore double the number of shares of that company. But the dividend weights of all the other stocks in the index have thereby been reduced, requiring a few shares of each to be sold. All fundamentally weighted indexes incur reasonably high turnover to align the portfolio weights with the changing fundamental factors. In addition, fundamentally based ETFs generally have lower operating costs and lower turnover than actively managed fund.

The ETF creation/redemption Process

Creating an ETF is a multistep process. First, authorized participants assemble a collection of stocks that replicates an underlying benchmark index (Authorized parties would typically be market makers, specialists on the exchange floor, large institutional investors, and professional arbitrageurs)

Second, upon collecting the underlying stocks, the authorized participant notifies a distributor, usually either APLS Mutual Funds Services or SEI Investment Services, of its intention to assemble creation unit. The creation units are composed of large blocks of stock that replicate, or very closely mimic, the behavior of the underlying benchmark index.

Trustees are not permitted to lend out the securities held in the replication portfolio.Dividends cannot be reinvested. Typically they are paid to the trustee and redistributed to ETFshareholders. Some of the more popular ETFs use this structure, among them SPDRs, DIAMONDS, and QQQQs, based, respectively, on the S&P 500, the Dow Industrials, and the Nasdaq 100. Other ETFs are structured as open-ended mutual funds. As such they are not encumbered by the same restrictions as unit investment trusts. For instance, an ETF structured as an open-ended mutual fund is not required to exactly replicate its underlying index. It may instead use statistical techniques to construct a portfolio that mimics the index without exactly replicating it (Wiandt& McClatchy, 2001).

ETFs generate low turnover to the extent that benchmark composition is stable, a situation that applies equally to conventional but passive mutual fund index funds. It is turnover by actively managed mutual funds that generates taxable events over which fund owners have no control. In addition, it should be noted that active trading of ETFs will generate tax and transaction costs as well. Annual expense fees for ETFs vary by the fund, but tend to be low for the bigger, more widely followed indexes. If an individual loses money because the stocks or ETFs move in the opposite direction, no one will provide insurance against the loss. For instance, SPDRS have an annual expense ratio of only 0.1%. The expense ratio for DIAMONDS is 0.18%; for the Russell 2000 it is 0.20%; for the QQQQs the annual expense ratio is 0.20% (Wiandt& McClatchy, 2001).

The Mechanics of Exchange Traded Funds

Exchange-traded funds represent shares of stock in a fund or unit investment trust. ETFs are relatively new, combining the liquidity of a listed stock with the diversification advantages normally associated with a traditional mutual fund. The structural features of ETFs that facilitate this are briefly touched on here. But for a detailed analysis readers are advised to consult David Lerman’s book: Exchange Traded Funds and E-Mini Stock Index Futures.6Typically an ETF seeks to replicate the returns of a benchmark stock or bond index, although recently some ETFs have been launched against baskets of commodities.

Figure 2(London Stock Exchange, 2009)

Individual acquires exchange traded funds shares, they do not create them; the shares have already been created. They can buy them from another investor, as they would for a closed-end fund. The Exchange traded funds shares were not created all in one fell swoop in an initial public offering (IPO), as would occur for an individual stock, a closed-end fund, or a unit investment trust. Exchange traded funds shares are created and redeemed by the trust. In this regard, Exchange traded funds resemble open-end funds, which create and redeem their shares according to shareholder demand. What makes exchange-traded funds unique is that the creation and redemption of the ETFs is that they are exactly opposite to the mutual fund shares.……..incomplete sentence?(Wild, 2011).

Transaction costs can exact a punishing toll on returns. But there are ways to minimize or at least reduce transaction costs while still maintaining an active trading profile. Execution costs for trading in ETFs just like equity index futures are comparatively low. I thought you are still talking of ETFs?Virtually all the major equity indexes have futures contracts listed on them; the markets are transparent and easy to access electronically. For active equity index trading, futures contracts warrant a close look. For traders, during the day as the markets move up and down, you can trade ETFs as you would individual stocks, taking advantage of rallies and dips. Because you are trading a market segment, you are not subject to the high risk of trading a single issue. For investors, you can buy a market segment or indexing methodology or any of a host of ETF offerings, hold that exposure as long as you want, for years even, and probably have taxable events such as receiving dividends and interests and also sell of securities. For example?

Trading in Exchange Traded Funds

If the market is tumbling and people want to short the market to take advantage, they don’t have to wait for an uptick with an ETF. This securities class is exempt from the downtick rule, and you can short in a falling market. If an investor wants to short the market but don’t know what to short, just that they want a market proxy to follow the market direction that you think is downward, you could short SPY. SPY is the symbol of one of the S&P 500 Index ETFs. Say that SPY is selling at 145.20 a share and starting to drop. As stated, with a stock you have to wait for an uptick or zero uptick, but with ETFs you can short anytime. You could callyour broker and get stock protection for when you want to cover (Abner, 2010).

Before buying an ETF, especially a lesser known one, traders should watch the trading for a while to make sure that the trades are near the bid andask for the prices. Sometimes they should put in market orders to make sure that orders are executed near the bid and asked prices. When trading in aless active ETF, you could use limits on buys and sells, at least untilyou get comfortable enough to trust the trading in that ETF to entermarket orders. Creations and redemptions are performed on a continuous basis on an ETF’s net asset value (NAV). The NAV represents the total value of all the investments an ETF owns. This figure includes the value of the securities the ETF is holding, any cash components in the ETF, and any other assets, such as derivatives. When the participant delivers the basket of shares to be converted into ETF shares, it also brings cash to the fund (Abner, 2010).

In the ETF creation and redemption structure the money flows from the buyer to the broker, through the ETF market maker, to the ETF creator. The ETF creator creates the ETF shares, flows them through the ETF market maker, and back to the buyer. An important category of exchange-traded funds tracks indexes of foreign markets, such as those of France or Brazil. The indexes are creations of Morgan Stanley Capital International, Inc. (MSCI). With these ETFs, a single company, again, may dominate. The capitalization of Ericsson, for example, is considerably larger than that of any other Swedish company. The effect of that company on the ETF for the Swedish stock market is disproportionate.

The underlying trading value of an ETF is calculated every 15seconds during the day. It represents the value of the stocks held by the trust, plus the cash, all divided by the number of outstanding shares of the exchange-traded fund. The value of each stock in the trust is based on the last traded price and does not allow for an estimate of any change in the price due to the possibility that, for example, trading in the stock may have been halted. For Exchange traded funds, the underlying trading value may be found with electronic equipment, using the symbol SXV. The underlying trading value is calculated throughout the day, and the net asset value is calculated only at the day’s end.

But the underlying stocks of some exchange-traded funds cannot be bought or sold quickly. The volume of trading in those stocks is relatively light, and so is the volume of the corresponding ETFs. Try though they might, arbitrageurs cannot get their trades executed quickly. The variances in those exchange-traded funds therefore range more widely than they do for the more active ETFs. The same applies to the ETFs of foreign markets. Many foreign stocks are not as liquid (that is, cannot as readily be bought or sold) as U.S. stocks. The trading volume tends to be lower. Also, an arbitrageur may take a position on one side of the market for ETFs. Without it, price fluctuation is increased.

ETFs trade-in the same markets as the underlying securities. Since the ETFs are used as hedges, market stability is increased.

Operating Costs: The operating costs of exchange-traded funds are remarkably low. There are no charges to pay for market costs however operating costs are only associated with the various types of the investment funds.  and such charges are present in which investment vehicles / types?. The operating costs range from 9 basis points (0.09%) to 99basis points (0.99%) per year. The high-cost varieties are the ETFs of foreign markets. The deduction of operating costs from the trust on a daily basis is one aspect of ETFs that favors the trader.

Investors who want low-cost, diversified, tax-efficient investments that they can buy, and sell, in the same way as ordinary stocks and bonds might discover that a well-structured ETF beats a similar mutual fund hands down; especially net of all the expenses that nobody likes to talk about.  Investors should choose an investment instrument based on Individual circumstances, such as willingness to incur or avoid risk, age before retirement, need for immediate income, and knowledge of the markets. Exchange-Traded Fund (ETF): An investment company set up either as an open-end company or a unit investment trust (UIT). Its shares (underlain by a basket of securities) trade intraday on a stock exchange at prices determined in the market. ETFs are bought or sold through brokers the same way that publicly traded companies are.

ETFs differ from other open-end companies and unit investment trusts because their shares trade only on regulated exchanges. Some ETF sponsors assert that they handle the reinvestment of dividends. Don’t be confused by this. Here’s what the sponsors mean: As is true of regular mutual funds, the dividends paid by the stocks owned by the ETF are added to the ETF’s cash value and become part of the net asset value of the trust. Exchange-traded funds open up new windows for technical analysis. They trade during the entire day, with the spreads, prices, and volume figures widely promulgated.

This should all be consolidated at the beginning of your work i.e intro of what ETF isETFs are bought or sold through stockbrokers the same way that the shares of publicly traded companies are. Surrounding the specialists arebrokers who buy and sell ETFs throughout the day. This trading market usually keeps ETF prices near their IPV. Brokers know what theIPV is and the market price and will buy or sell an ETF if and when differences widen between these two prices.

ETFs can be used to replicate hedge fund strategies, take market-neutral positions, and create synthetic positions using derivatives. Investors can-not use mutual funds to pursue those investment strategies.

Exchange-traded funds are a very new type of mutual fund that was first established in 1993. This type of fund has developed rapidly and it now holds approximately $80 billion worth of assets. ETFs are often described as tax efficient when compared with traditional equity mutual funds; this is because in the recent years, very large exchange traded funds  have made a small contributions of taxable and realized capital gains than majority of other mutual funds. This paper will provide an introduction into the operations of exchange traded funds. This essay will seek to proof that exchange traded funds  provide taxable investors with a  secure method of holding a lot of stock that can deliver returns that are comparable to those provided by low-cost index funds.

Exchange traded funds are growing rapidly as the favorite financial product class. They are typically organized in the form of unit trust. Exchange traded funds were introduced in the year 1993 and by the close of the year 2001, it was holding $79 billion worth in the assets; this was 2.4 percent of the total equity funds. The equity share mutual fund assets that were held through the exchange traded funds doubled in the year 2000 and increased by almost 50 percent in 2001. With the many years of increased growth witnessed by ETF, the assets it is holding will rival the amount that is held in the equity index funds (Richards, 2003).

Contribution of Exchange Traded Funds to the Field of Investment

Exchange traded funds are of great significance to the researchers of public finance that are concerned with portfolio and taxation behavior for the following tow reasons:  First, ETF represent new financial innovations that is described as the prototype of the evolution of mutual fund industry. This makes it imperative to put into their consideration their tax treatment as well as after tax returns. Secondly, exchange funds transfer is marketed as being tax efficient as compared with traditional equity funds. Through the reduction of tax burden on corporate stocks investment in relation to investments in such stock held via equity mutual funds. Exchange traded funds often move closer to consumption-tax treatment of the corporate capital returns (Richards, 2003).

Mutual funds such as ETFs are often subjected to special tax rules; they must in particular pass their realized capital returns to their shareholders. This will raise the mutual fund tax burden to investors; this tax burden will be pecked relative to the tax burden on the buy-hold securities portfolio of securities.When for example a fund manager sells shares that have appreciated, buy and hold type of investors in the equity mutual fund become taxable on the realized capital gains of the funds. ETFs are mutual funds technically and are therefore governed by similar tax rules; though they use redemption in kind technique to reduce or completely eliminate the realized capital gains distributions. This will account for historical tax advantage that is related to various traditional equity mutual funds (Abner, 2010).

How to Trade on Exchange Traded Funds

ETFs are traded as securities. The first exchange traded funds were traded on American Stock exchange and later was traded in the New York Stock Exchange.  Every exchange traded share is considered as a claim on trust holding a certain asset pool; the SPDR trust for example holds its stocks in the S&P500. EFT shares are often created when a financial institution that is authorized deposits portfolio of securities with a trustee and in return receives ETF shares which can be sold to other willing investors (Frush, 2012).

Comparison of Exchange Traded Funds with Index Funds and Mutual Funds

ETF share market operates just like common stock share market. Investors can purchase or sell ETF shares at any hour of the day.  The price of exchange traded shares can at times diverge from the underlying net asset value of the securities that are held in trust, although the divergence may be limited by the capacity of the financial institution that is authorized to redeem and create the exchange traded funds.  In the event the exchange traded funds share price increases above the Net Asset Value (NAV) for underlying assets, the institutions creating it will purchase associated securities and deposit them in trust hence creating new exchange traded shares.  In the event the exchange traded funds share price decreases below net asset value of underlying asset, the authorized institutions will purchase exchange traded funds and in turn return them for underlying securities (Frush, 2012).

Exchange traded funds can be bought through brokerage firms, this will include commission costs. You can purchase at a margin and sell them short. It is these features and the opportunities to trade through exchange traded funds daily that differentiates it from other traditional equity mutual funds. You can only buy or sell mutual funds when the day to day asset value ends.  In various instances, mutual funds can be bought without a commission and directly from fund complex; this is when compared to ETF that attracts commissions.  Mutual funds shares can be sold at a short or bought at a margin.

These differences between ETF and mutual funds indicate that they are both appropriate for different categories of investors. For those investors demanding short term or immediate liquidity and those who do their purchases in bulk, ETFs is their better option  while  mutual funds is for those investors  who make very small purchases or sales and for investors who place limited value on liquidity (Anderson, Born,  &Schnusenberg, 2010).

ETFs are bought and sold throughout the day at the market price, usually close to the net asset value (NAV).Creation and redemption process, which usually creates no tax event shorted on a downtick or zero downtick.  Mutual Funds Bought and sold at the NAV; fees and expenses can be added at the end of the trading day. Exchange-traded funds (ETFs) have much more stability than individual stocks, less expensive than the majority of mutual funds, and subject to minimal taxation.

The above differences notwithstanding, exchange traded funds are the same as mutual funds in various aspects.  They all require operating expenses that minimize the returns of the investors. Most exchange traded funds are designed to tract certain market index; this makes them to resemble equity index funds.  Index funds and ETFs experience similar tracking error when it comes to matching index pre-tax return. Mutual funds and ETF differ when it comes to their expense ratios and their tracking error; they also differ in their relationship between their net asset value and the purchasing price from underlying securities. Regarding after tax basis, the difference in the capital gains realization between equity index funds and ETF might result in differences in the returns (Maeda, 2009).

Figure 1 below is for illustration purpose and shows clearly the difference between a tracking error and tracking difference.

Figure 3(BlackRock, 2013)

In figure 1 above, among the two ETFs, it is ETF 1 that has a huge tracking error than ETF 2. However, ETF 2 has an almost zero value for its tracking difference but on the other hand, ETF 1 has a huge tracking difference.

Generally, the expenses ratio on the exchange traded funds invested in specific industries such as US stocks are very high than the expenses ratio for ETFs meant for domestic securities.  The expenses ratios for many ETF shares are often below the expenses ratio for mutual funds and index funds.  When the owner of an index fund redeems, he or she receives cash. The fund may have to sell stock to provide it. This incurs transaction and tax costs that are borne by all shareholders, not just the one who’s selling. The fund also tends to sell its high-cost assets, leaving behind low-cost assets that create a potential tax burden another disadvantage to long-term holders. With exchange-traded funds, an authorized participant who redeems receives stock in exchange (Maeda, 2009).

The spreads of exchange-traded funds remain narrow even for large transactions. Indeed, ETF spreads are usually lower than the average spreads of the underlying stocks. This is because the investor in ETFs (for large trades, more likely an institution) is in effect buying a substantial fraction of an entire market rather than the shares of a single company. The market impact of the trade is dispersed among many stocks (Anderson, Born, &Schnusenberg, 2010).

  Stock ETF Traditional Mutual Fund
Diversification of Investment Low individual securities High-Basket of securities Depends on different funds- Basket of securities
Pricing Continuous intra-day pricing Continues intra-day pricing Daily quote after market close
Liquidity Varies Comparatively higher Limited liquidity
Transparency Varies Comparatively higher Low transparency
Fee Varies Comparatively lower Varies
Short-selling Yes Yes No
Limit order Yes Yes No


Within a single brokerage account, you can allocate your money among any number and any type of exchange-traded funds. Later, to rebalance the portfolio, you can easily move funds from one ETF to another. But unless you use a single mutual fund family, no such flexibility is available with index funds. Moving funds from one mutual fund family to another is unwieldy, and while the money is in transfer the prices may move against you.


Exchange traded funds are those investment companies classified either as Unit Investment Trusts (UIT) or open-end companies. Using exchange trading funds in your trading company strategy can assist you in hedging risks, diversifying your portfolio and increasing market exposure.  This trading strategy should form part of your portfolio.   ETFs differ from traditional open-end companies and unit investment companies in the following ways:  ETFs don’t sell individual shares directly to investors and only issue their shares in bulk, investors don’t purchase creation units with cash but buy with units of basket securities, investors can purchase creation units, split them and sell as individual shares, investors can sell their exchange traded shares as individual shares or creation units.

ETFs seek to realize similar returns at a certain market index; it can either invest as company securities or as a representative sample of the securities.  Various types of ETF are invested differently; Spiders for example are only invested in stocks that are found in S&P500 stock index while others like leveraged or inverse exchange traded shares that are geared toward gaining daily returns.

You have good ideas and have done good research. However, your presentation is weak. There are gaps in explanation and you jump around quite a bit. You need good structure& solid explanations for superior results.

For example after your Title of work&Purpose of study; define ETF – what it is, characteristics, types; participants in ETF; uses of ETFs; comparison of ETFs vs MF and other asset types etc. look at each piece exhaustively




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Anderson, S. C., Born, J., &Schnusenberg, O. (2010). Closed-end funds, exchange-traded funds, and hedge funds: Origins, functions, and literature. New York, NY: Springer.

BlackRock. (2013). Understanding ETFs. Retrieved from:

Frush, S. P. (2012). All about exchange-traded funds: The easy way to get started. New York, NY: McGraw-Hill.

Hehn, E. (2005). Exchange traded funds: Structure, regulation and application of a new fund class. New York, NY: Springer.

London Stock Exchange. (2009). Exchange Traded Funds. Retrieved from:

Maeda, M. (2009). The complete guide to investing in exchange traded funds: How to earn high rates of return–safely. New York, NY:: Atlantic Pub. Group.

Richards, A. M. (2003). All about exchange-traded funds. New York, NY: McGraw-Hill.

Richards, A. M. (2007). Understanding exchange-traded funds. New York, NY: McGraw-Hill.

Wiandt, J., & McClatchy, W. (2001). Exchange traded funds. New York, NY: John Wiley.

Wild, R. (2011).Exchange-Traded Funds For Dummies. Hoboken, NJ: John Wiley & Sons, Inc.