Their passive nature is a necessity: As we’ll explain later, the funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund’s holdings. Active managers, however, are loath to disclose such information more frequently than the SEC requires (which currently is once a quarter).
The Three Features of ETFs
1. A passive management style
| ETF managers only make changes to ETF portfolio when there is a change in the underlying index. Investors holding ETF beneficiary certificates can perform the trading just like stocks so that capital gain can be enjoyed when the Index increases. The value of an ETF share rises and falls depending on the performance of the underlying index. And, of course, the performance of the index is determined by the performance of each component stock. |
2. Possessing the characteristics of both stocks and mutual funds
| ETFs are similar to index mutual funds, but are traded more like a stock. As their name implies, Exchange Traded Funds (ETFs) represent a basket of securities that are traded on an exchange. As with all investment products, exchange traded funds have their share of advantage and disadvantages. Being similar to stock, exchange traded funds offer more flexibility than your typical mutual fund. |
- ETFs can be bought and sold throughout the trading day, allowing for intraday trading - which is rare with mutual funds. Traders have the ability to short or buy ETFs on margin.
- Low annual expenses rival the cheapest mutual funds.
3. Allowing in-kind creation/redemption
| Investors may apply for creation / redemption of ETF through participating dealers so that those dealers can carry out in-kind creation / redemption for itself or on behalf of its customers. The process by which participating dealers transact directly with the fund on an in-kind basis. Creation / redemption occur in Creation Unit aggregations or multiples thereof and involve delivering a specified basket of securities to the fund in exchange for ETF shares and vice versa. |