The Practical Guide to Wall Street: Equities and Derivatives

CHAPTER 6

Exchange-Traded Funds (ETFs)

INTRODUCTION

An exchange-traded fund (ETF) is a type of open-ended investment company that uses the money deposited with it to purchase a portfolio of stocks (or bonds) that replicates the returns of a reference index. The ownership of the assets of the fund is recognized through the issuance of shares. The term open-ended indicates that the number of shares of the fund is variable—as new money is deposited, new assets are purchased and new shares are issued, without limit. The notional amount of new shares issued is always strictly equal to the money deposited with the fund and therefore is not dilutive to the holdings of existing shareholders. The initials “ETF” are generally used to refer to the shares of an ETF, while the actual entity that issues them is referred to as the fund or the ETF sponsor. In terms of their investment objectives and structure, exchange-traded funds are very similar to passive index funds. There are, however, several important differences between the two products, and it is precisely these differences that have made ETFs so popular.

The first is that ETFs trade like stocks. In a traditional fund, all purchases and sales of fund shares must be made with the fund itself, and this can only be done at the closing net asset value (NAV)¹ of the fund on the day of the trade. All orders submitted during the day receive the same execution price at the close. Funds only publish a single valuation of the fund shares ...