Over the past decade, ETFs have become so popular that many market participants consider them perhaps one of the most successful financial products ever designed.

Exchange-Traded Funds (ETFs) provide exposure to an entire index through a single financial vehicle. ETFs trade like any other stock on the stock exchange during market hours and can be both shorted and margined.

The difference remains that ETFs are still shares in a portfolio of stocks and not in an individual company. As far as ownership is concerned, ETFs are shares in either open-end funds or in unit investment trusts that mirror a portfolio of stocks or bonds of an underlying index, or a sector, region or fixed income.

Popularity of ETFs

The first ETFs appeared in Canada as TIP 35 (Toronto Index Participation Fund) in 1989, followed in the U.S. four years later by SPDRs (S&P 500 Depositary Receipts). In Asia, the first ETF was Hong Kong Tracker Fund, launched in 1999. In Europe, it was Euro STOXX 50 in 2000, while Japan held out the longest, listing eight ETFs for the first time 2001.

By 2002, there were 102 ETFs in the U.S., 14 in Canada, 106 in Europe and about 24 in Asia, closing in on $130.0 billion in total global assets under management. The latest ETFs in the U.S. are of the fixed-income variety, which entered the stage in 2002 on the American Stock Exchange.

Structure of ETFs

In the U.S., ETFs are structured as three legal types:

• managed investment companies;
• unit investment trusts; and,
• grantor trusts.

Managed Investment Companies

Managed investment companies are opened-ended companies that are considered the most flexible of all three ETF structures. This is because ETFs can track an underlying index in a number of ways, such as holding only a sample of the securities included in the index.

In addition, these ETFs can lend securities and trade in derivatives. Dividends paid on securities included in the index are automatically reinvested. Examples of managed investment companies ETF structure are sector SPDRs, iShares and WEBS.

Unit Investment Trusts

Although unit investment trusts (UITs) are managed investment companies as well, they operate under a more stringent mandate because there is not a single manager per ETF, but rather a trustee or trustees have that job.

The difference is that UITs must be invested in all of the securities comprising an underlying index. Furthermore, any dividends received must be held in cash and paid out when due to shareholders, which, of course, may have somewhat of an adverse impact on the UIT’s overall performance. Finally, UITs are not allowed to lend securities and typically do not trade in derivatives.

Grantor Trusts

The last structure of ETFs available in the U.S. is a grantor trust, which is not a registered investment company. In essence, holding a grantor trust is very close to holding a basket of securities. On the U.S. stock exchanges, grantor trusts are often traded as American Depositary Receipts (ADRs).

Since grantor trusts are fully invested in a basket of securities, the trust is generally not required to exercise discretionary management. As a result, grantor trusts are unregistered and generally have a limited life. Also, dividends are usually paid to shareholders right away, while lending of securities and derivatives trading is not a common practice. For example, HOLDRs are grantor trusts.

Redemption of ETFs

Generally, shares of ETFs can be redeemed in cash. However, such in-cash redemption practice is discouraged by either slapping large redemption fees or by calculating net asset value (NAV) two days after the redemption. That way, the investor does not know what will be the redemption value in advance and that often serves as a deterrent.

In any event, if an ETF shareholder is bent on selling its shares, the best thing to do is to sell their ETFs in open market transactions. This means that there has to be a market maker in an ETF, who will maintain bid and ask prices, maintaining a rather narrow spread. That way, an ETF shareholder can sell his or her shares and immediately obtain cash for them, minus a broker’s commission, of course.

Source: International Investments, Fifth Edition, by Bruno Solnik and Dennis McLeavey, 2004.