APPENDIX 1

ETFs 101

An exchange-traded fund (ETF) trades on a stock exchange like any stock, holds a portfolio of stocks, commodities, or bonds, and uses arbitrage to keep its trading price close to its net asset value. Most ETFs track a stock index or bond index and are low cost and tax efficient. In 2008 the Securities and Exchange Commission began to authorize actively managed ETFs.

ETFs had their genesis in 1989 with Index Participation Shares, a proxy for the S&P 500 index that traded on the American and Philadelphia stock exchanges. A lawsuit by the Chicago Mercantile Exchange successfully stopped sales in the United States. A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. These shares, which tracked the Toronto Stock Exchange’s TSE 35 and later the TSE 100 indexes, proved popular. This led the American Stock Exchange to try to develop something that would satisfy SEC regulations in the United States. Nathan Most and Steven Bloom, under the direction of Ivers Riley, designed and developed Standard & Poor’s Depositary Receipts, introduced in January 1993. Known as SPDRs or “Spiders,” the SPDR 500 Trust (ticker: SPY) became the largest ETF in the world.

Barclays Global Investors (BGI), in conjunction with MSCI as underwriter, entered the market in 1996 with World Equity Benchmark Shares (WEBS) to give investors easy access to foreign markets. In 1998, State Street Global Advisors introduced Sector Spiders, which follow nine industry sectors of the S&P 500. In 2000, BGI put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. iShares created the first bond index funds in July 2002, based on US Treasury and corporate bonds. Within five years iShares had surpassed the assets of any ETF competitor. BGI was sold to BlackRock in 2009 (see Chapter 14).

Vanguard entered the market in 2001 with a single ETF—Vanguard Total Stock Market ETF (ticker: VTI).

Advantages of ETFs are:

•   Low costs. ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs do not have 12b-1 fees.

•   Trading flexibility. ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be bought or sold at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short.

•   Tax efficiency. ETFs generate relatively low capital gains, because they typically have low portfolio turnover and an in-kind redemption mechanism.

•   Market exposure and diversification. ETFs provide an economical way to rebalance portfolio allocations or to “equitize” cash by investing it quickly.

•   Transparency. Whether based on index funds or actively managed, ETFs have transparent portfolios that are priced at frequent intervals throughout the trading day.

ETF distributors buy or sell ETFs directly from or to authorized market participants in “creation units,” blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities. Market makers on the open market exchange creation units with the underlying securities to provide liquidity for the ETF shares, and help ensure that their intraday market price approximates the net asset value of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares in this secondary market.