ETFs Part 1: What You Should Know About Exchange Traded Funds

As back-to-school season approaches, we in the NYSE Exchange Traded Products (ETP) Group thought it would be a good opportunity to post educational blogs on ETPs -A summer school crash-course for investors on ETPs. Over the next few weeks, we will cover the basics on Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs), and Exchange Traded Vehicles (ETVs) discussing their structure, how they trade, and what types are available.

First, we’ll start with ‘ETFs Part 1: What You Should Know about Exchange Traded Funds’. ETFs are increasingly popular investment vehicles, totaling over $1 trillion1 in assets under management (AUM) in the US. Before you decide to invest, there are some basic questions you should consider in order to make an informed investment decision.

What are Exchange Traded Funds?

An ETF is an investment product that allows an investor to buy and sell shares in a single security that represents a fractional ownership interest in a portfolio of securities. Legally, ETFs are open-ended investment companies or unit investment trusts that are registered under the Investment Company Act of 1940.  Traditionally, ETFs tracked a benchmark index; however, recently actively managed ETFs have become more prevalent.

ETFs are one type of structured exchange-traded product. There are other types as well, but they do not share all the characteristics of ETFs, even though they may be referred to as such in the popular press and on some websites. Examples of these other investment products include exchange traded notes (ETNs), equity linked notes, closed end funds and exchange traded vehicles (ETVs), among others.

What kinds of ETFs are available?

The first ETF, SPDR® S&P500®, was listed in 1993 with an underlying portfolio designed essentially to replicate the performance of the S&P 500® index. As of July, 2012, close to 1,200 ETFs have been launched allowing investors to gain exposure to a wide range of investment strategies and asset classes including broad stock indexes, industry sectors, fixed income indexes,international and global indexes, and active strategies.

Traditional ETFs are generally designed to track an underlying index while others attempt to replicate a multiple or the inverse of the daily return of an underlying index. For example, one fund replicates twice the daily return of the Dow Jones Industrial AverageSM. The “short” or “inverse” ETFs replicate the inverse of the daily returns of the underlying index. Leveraged and inverse ETFs will be discussed more in future blog posts.

Another new type of ETF strategy is the actively managed portfolio. Unlike traditional ETFs, actively managed ETFs permit the fund manager to buy and sell securities and derivatives according to a stated strategy,described in the prospectus. As a condition of operations, the portfolio or fund holdings are disclosed daily on the fund’s website.  As of July 2012, there are over 50 actively managed ETFs.

How are ETFs traded?

ETFs are listed on a national securities exchange such as NYSE Arca,.  As listed securities, ETFs can be bought and sold like common stocks throughout the trading day. Individual investors may purchase or sell an ETF through a stock brokerage account. Investors may enter the same types of orders that are placed for shares of stock (including, for example, market and limit orders). There are also listed options on some ETFs.

What are some risks involved in investing in ETFs?

As with any investment, there are a variety of risks to consider before investing in an ETF. Some common risks are ETF Risk (the risk that the Net Asset Value (NAV) of an ETF can fluctuate, and the risk that the market price for an ETF can trade either above or below the fund’s NAV), Investment Style Risk, Liquidity Risk, and Market Risk. Please be sure to read a fund’s prospectus for a full list of applicable risks before considering investing.

Stay tuned for next week’s post on the creation/redemption process!