In recent years, especially in the USA, there has been a rapid increase in exchange traded funds (ETFs). The first ETF traded in the USA in 1993 and they commenced trading on European exchanges in 1999. An ETF is an open ended investment vehicle, which invests in a variety of securities. lts creation is very different from that of a mutual fund.
A sponsor or ETF manger files a plan with a relevant body (for example,the Securities Exchange Commission in ‘the USA). Following approval, the sponsor forms an agreement with an authorized participant such as an institutional investor who has authority to create or redeem ETF shares. The authorized participant will then borrow or buy shares from pension funds and other institutional investors, typically in bundles of 10,000 to 500,000 shares. These shares are then divided up to form creation units; for example, a bundle of 50,000 shares might represent 1 creation unit. As such, a creation unit represents a claim on some underlying assets. The creation units are then divided up by the sponsor into individual shares – or ETFs – which are traded on stock exchanges like an ordinary share although they represent a claim on a bundle of shares.
When shares in the ETF are bought and sold the underlying assets that were borrowed to form the creation units remain in the trust account. The trust sponsor will pay out dividends from shares help by the ETF to holders of ETF shares. A holder of an ETF will typically redeem their holding by selling the ETF at the prevailing market price to another party. If an institutional investor buys enough ETF shares they can then approach the ETF trust for the return of shares equivalent to one creation unit, and when they do so that creation unit no longer exists. More creation units can be formed if the sponsor obtains more shares.
Originally ETFs were traded by institutional investors such as mutual funds, but they have become very popular with retail investors as well.
What the ETF does is dead simple. The ETF does what it says on the tin. For example, the Footsie ETF would move up and down exactly in line with’ the Footsie index, second by second, tenth of a point by tenth of a point.It is always spot on. And you can get regular dividend payments just as with a normal tracker fund.
You can save money as well. Derivatives don’t attract UK government stamp duty, which takes 0.5 per cent up front from your other shares investment
money. Otherwise, charges are similar to those imposed at the low end of the unit-trust trackers’ fee range.
You can use derivatives for all sorts of complicated strategies. The easiest is shorting, meaning that you can sell the ETF if you think the index is due to fall
and then buy it back later at a lower price. The gap between the two is your profit (or loss).
ETFs are big business in the United States and increasingly in Europe as well. When they get better known, they’ll be big in the UK as well. Currently you can buy into the Footsie, the Eurostoxx and the Standard & Po0r’s 500 ,via UK-quoted ETFs. But things don’t stop there. If you want you can find an ETF to invest in international pharmaceutical companies, the,price of wheat or even one that finds shares in agricultural machinery firms. This means that you can access a portfolio of shares in an industry or country that might otherwise be difficult to invest in. Where a demand exists either real or foreseen, some investment bank or another comes up with an ETF.
So although once ETFs limited themselves to the big Japanese ir UK stock markets, now you can get literally get hundreds of them.Some can be really esoteric. Take the ETF that invests in companies making farming implements, for example. It’s a great, low-cost way to buy into agricultural price boom because farmers replace their tractors when they see they’re getting more for their crops.
Fancy the fortunes of gold-mining companies but haven`t the first idea which shares to buy? Don’t worry, there’s an ETF for you. And another that just tracks the gold price (rumour has it that it’s backed by a big warehouse full of bullion). Likewise, drugs companies, oil firms – in fact almost anything you can think of.
Investment banks create ETFs. Banks can go bust. The danger always exists even though tiny, that the bank may not be able to meet its liabilities.
Check on the fund’s costs before buying – anything over 0.5 per cent a year should ring alarm bells. And always check on the names of the manager, trustee and custodian.
