Exchange Traded Funds

First introduced in 1990 on the Toronto stock exchange and in 1993 on the American market, the exchange traded fund has increased in popularity from a little-known alternate to open-ended index funds to an investment industry in itself with over one hundred ETFs with assets of over one-quarter trillion dollars worldwide and almost $180 billion on the American stock exchange alone.

The exchange traded fund is an open-ended collective investment differing from standard mutual funds in quite a few ways. In similar fashion to that of investment companies, ETFs must be registered with the Securities and Exchange Commission as such. After creation of the ETF itself, the institutional investor deposits a block of securities within it; for the deposit, the institutional investor gets ETF shares which may in turn by traded on the stock exchange once listed in any national exchange.

As an investment, ETFs potentially promise the best of two worlds within stock market trading. ETFs offer the diversification and relative security inherent in an actively managed mutual fund while also allowing investors the freedom to buy and sell ETF shares just as he or she can buy and sell the stock of a publicly traded company. ETFs also feature a few distinctive advantages, with the typical ETF carrying low expense ratios, low turnover, and an advantageous tax structure.

Since the ETF is a relatively new phenomenon, and since so many ETFs are able to take advantage of technological advances and trends in e-commerce, innovations come fairly frequently to the market. On the other hand, the ETF market is notably stable, and the most widely held ETF is Standard & Poor’s Depository Receipt (abbreviated SPDR and commonly known as “spiders”), a format with origins back to the very first ETF ever traded in the United States. Other ETFs are tied in with the Dow Jones Industrial Average or the Nasdaq 100 index; these are known as “diamonds” and “qubes,” respectively. Funds known as “iShares” represent an ETF group created by Barclays Global Investors, the world’s largest institutional investor.

In terms of assets at the conclusion of year 2005, the list of top-ranked American ETFs includes the DIAMONDS Trust (Series 1), the iShares Dow Jones Select Dividend Index Fund, the iShares MSCI EAFE Index Fund, the iShares MSCI Emerging Markets Index Fund, the iShares MSCI Japan Index Fund, the iShares Russell 2000 Index Fund, the iShares Standard & Poor’s 500 Index Fund, MidCap SPDRs, Qubes, SPDRs, State Street Corporation’s streetTRACKS, and the Vanguard Group’s VIPERS.

As for the future, should ETFs retain their current level of popularity, the sky is the limit. Following the creation and release of the SPDR concept came ETFs based on the Midcap index and international exchange; the latter represented seventeen ETFs as far back as 1996. At the end of year 2000, assets of the fewer than ninety ETFs were calculated at approximately $83 billion; a mere four years later, those figures had increased to almost 180 funds (and 350 funds in the history of the investment) representing more than $230 billion on twenty-eight markets. Though we surely cannot expect an ETF investment to continue to grow at rates of 32-34 percent annually, as in 2003 and 2004, but with the continued innovation so characteristic of the ETF market, an ETF investment appears to be a secure one in at least the medium-term.

Part one. The history of ETFs

Though the concept of modern exchange traded funds quite clearly began in Toronto in 1989, its origins go back to 1976 and the creation of the index fund. At that time, John C. Bogle of the Vanguard Group conducted a study which showed that seventy-five percent of existing mutual funds earned as much as or less than the Standard & Poor 500 stock market index. If a mutual fund could be created that invested in all S&P 500, it automatically would be an improvement over the standard mutual fund of that time. The result was the Vanguard 500, a structure that theoretically is primarily concerned with shareholder interests, as opposed to mutual funds, which attempt to serve the interests of both outside owners and shareholders.

The ETF is a natural outgrowth of the index fund in its nature as an open-ended collective investment, with a subsequent few adjustments made thanks to modern exchange dynamics. Like mutual funds and index funds, ETFs must be registered as an investment company with the Securities and Exchange Commission. After creation of the ETF itself, the institutional investor deposits a block of securities within it; for the deposit, the institutional investor gets ETF shares which may in turn by traded on the stock exchange once listed in any national exchange.

As in index funds, investors are dealing with blocks of stocks in an attempt to regulate the stock market index; this reduces risk via the anchoring influence of blue chips while taking advantage of boom-time economies. However, ETFs can also be based in a market sector or even a commodity. Unlike mutual funds, individual shares within ETFs and index funds are not redeemable in part.

Recently added to ETF investment schemes is exemptive relief in the U.S. This allows their registration as mutual funds despite their status as not individually redeemable, it permits the trading of shares in kind, and share prices are pre-negotiated. This latter advantage refers to the intraday trading of ETFs and the market-determined prices can protect investors from a day’s worth of dramatically fluctuating trade; this feature is unique to ETFs, as is the requirement that ETF trading is done intraday only.

Since its introduction to the Canadian market in 1990 and the American market in 1993, the exchange traded fund has increased in popularity from a little-known alternate to open-ended index funds to an investment industry in itself. The Toronto Stock Exchange introduced the first ETF, known as TIPS, in January 1990. Under the auspices of the SEC’s Super Trust Order, American Stock Exchange interests put in a federal-level request to create an independent index-based ETF.

After a bit of wrangling and hashing out of details with the SEC and American federal law (including incorporation the Securities Act of 1933 and the Securities Exchange Act of 1940, which regulate mutual funds and, since the 1970s, any similar such investment instrument e.g. index funds), January 1993 saw the opening of the first ETF in the U.S. Based on the Standard & Poor 500 index, the S&P Depository Receipts Trust Series wasn’t followed up until 1995, when a new ETF tied into the S&P MidCap 400 index was added.

The popularity of ETFs soon began its steady increase, however. Seventeen ETFs based on international stock exchanges hit the market in 1996. In 1998, the Select Sector SPRD funds joined the market as yet another spider option. Stock exchanges worldwide began to respond to the new-fangled idea. In 1999, ETFs were introduced to the Tokyo Stock Exchange; an agreement between TSE and the American Stock Exchange in 2001 allowed cross listing and trading of ETFs between interests in the two nations.

Year 2001 proved to be a watershed year for ETFs internationally. In July 2001, the Australian Stock Exchange introduced an altogether new trading platform designed for listed investment funds created particularly in response to the still-burgeoning ETF market. Canadian, Hong Kong and Japanese stock markets launched different ETFs. Acceptance of the revolutionary investment scheme generally caught on as quickly outside North America as they had in the U.S. and Canada, as the market grew by 43 percent in a single year.

Surprisingly slow to leap into the fray was Europe; some have blamed this seeming hesitance on European Union bureaucracy. ETFs were only introduced on The Continent in 2001. By year’s end, however, an unknowing observer never would have guessed that European investors had been without this option for so long. With the first introduction came two ETF opportunities: SPDR Europe 350 and SPDR Euro, both based in firms across the EU. By year’s end no fewer than sixty-one ETFs existed on the European market, and by the third quarter alone, the assets within European exchange traded funds was more than $3.6 billion, an increase of fifty-eight percent over the previous quarter. ETFs were also rapidly unveiled in each of the EU 15 countries and, with the May 2004 accession of Poland, Hungary and the Czech Republic, ETF markets have been constructed in these nations as well, though the actual launching of any ETFs has yet to occure.

This decade has seen ETF assets grow at outstanding rates. In 2001, assets of the fewer than ninety ETFs were calculated at approximately $83 billion. The following year, assets passed $100 billion; in 2003 and 2004, this figure ascended to $150 billion-plus and then a whopping $225 billion-plus, a compound annual increase of approximately thirty-three percent. The ninety ETFs of 2001 has grown to about double that at year end’s 2005, with twenty-eight markets worldwide boasting a combined $230 billion-plus in assets.

With this explosive growth came innovative new ideas to the concept. In November of 2004, two-century-old Boston-based old dog the State Street Corporation learned a new trick: The firm launched a new version of the ETF known as StreetTracks Gold Shares. Exactly what it sounds like, GLD represented the first ETF to track a commodity; some estimates state that GLD had amassed a mind-boggling $1.5 billion-plus in assets within its first month of release.

That same month, the Standard & Poor’s Depositary Receipt reclaimed its status as the number one held ETF in America.

Statistics from March 2005 show that ETF assets represented about $229 billion, an equivalent of about three percent, of the $8 trillion mutual funds market. One hundred sixty-two exchange-traded funds existed, the great majority of which are equity index funds. One hundred ten of extant ETFs were tied in to domestic stock indexes for total assets of just under $180 billion; sixty-seven of these featured broad indexes and represented more than 88 percent of assets in domestic-based ETFs, whereas industry ETFs had assets totaling over $21 billion. Forty-six international ETFs possessed a cumulative total of $37.7 billion in assets, and six ETFs followed bond indexes to represent more than $11 billion in capital.

The ETF’s inexorable process outward continues; in April 2006 alone, a number of significant events further shaped the ETF possibilities. In a clear sign of the times, Shenzen Stock Exchange representatives recently announced the releasing of the first exchange traded fund on that exchange on April 24, 2006. The Shenzen Stock Exchange is one of China’s two stock exchanges; the second, the Shanghai Stock Exchange put an ETF on the market in April 2005.

Named the 100 ETF, the Shenzen exchange traded fund is tied into the Shenzen Stock Exchange’s top 100. The fund is managed by Yifangda Fund Management Co. Ltd. and, though comprised mostly of blue chip stocks, small- and medium-sized businesses with nice returns will be welcomed into the fold.

In America, about a week before the new Chinese ETF, Chicago index firm IPOX Schuster announced the release of the First Trust IPOX-100 Index Fund, yet another unique ETF; this one represents the first ETF that reflects initial public offerings on the U.S. market.

Also new to the American market is the United States Oil Fund, the first oil-backed exchange traded fund, as commodity investment becomes overwhelmingly popular. So noteworthy was the launch of this opportunity to place capital directly on crude oil prices that sponsor commodity pool operator Victoria Bay Asset Management LLC managed to convince American Stock Exchange authorities to host a bell-ringing ceremony in celebration of the release.

And finally, the London Stock Exchange announced the imminent introduction of the ETF Securities a fund, an investment scheme that the LSE brain trust figures will bring small investors into the fold. ETF Securities would be a combination of a wide range of commodities; word has it that the new ETF was a direct response to the surging of copper (a resource that has increased 400 percent in value in the last five years), zinc, silver and, to some extent, oil. While German, American and British investment brokers feature a number of mixed commodity index funds, the ETF Securities fund is promised to require smaller capital investment to earn returns on investment.

Part Two. ETFs today

Though the jury is still out on whether the typically high commission which must be paid out to institutional investors, the truth is that statistics show that the Standard’s & Poor 500 brings higher returns than eighty percent of managed funds (even topping Bogle’s original vision).

As an investment, ETFs potentially promise the best of two worlds within stock market trading. ETFs offer the diversification and relative security inherent in an actively managed mutual fund while also allowing investors the freedom to buy and sell ETF shares just as he or she can buy and sell the stock of a publicly traded company. ETFs also feature a few distinctive advantages, with the typical ETF carrying low expense ratios, low turnover, and an advantageous tax structure. Since the ETF is a relatively new phenomenon, and since so many ETFs are able to take advantage of technological advances and trends in e-commerce, innovations come fairly frequently to the market.
The majority ETFs have a noticeably lower expense ratio than mutual funds. The ETF expense ratio almost never tops one percent, while rates of 0.1 percent are common; mutual funds, on the other hand can bring a ratio of three percent or even more.
In America, the typical ETF is more tax efficient than mutual funds in many areas. Under U.S. tax law, when a mutual fund achieves a capital gain that is not balanced by a loss, the mutual fund is required to distribute capital gains to shareholders by the end of the quarter. This happens when large fluctuations strike the index, usually when a panic occurs and a large volume of stock is pulled from the index. Said gains are taxable to shareholders, whether reinvesting in further fund shares or not. The ETF, meanwhile, is not redeemed by the stockholders and investors are allowed to merely sell in open trading. The result is investors realizing capital gains only when they choose to sell their own shares.
Indeed, ETFs are often chosen because of their features similar to stock. Trading with ETFs can take place in essentially the same fashion as shares in the stock market, with options to buy on margin, limit order, sell short or use a stop-loss order at the ETF investor’s disposal. None of these freedoms are offered with a mutual fund. In open-end funds, investors can sell only at the closing price of the mutual fund. Stop-loss orders basically become irrelevant and the ETF investor is much less at the whim of stock market flights of fancy. ETFs are priced throughout the day and heavy losses can be avoided by the vigilant.
The argument against ETF investment is mainly all about commissions, but these can be avoided and/or softened. When using a 401(k) or IRA scheme to base a portfolio in, a direct investment into a mutual fund company allows the investor to pay taxes rather than commissions.

Paths to success in ETF investment are surprisingly simple and number three. First, of course, is the above-mentioned tax hedge. Assuming the tax rate paid on returns is lower than the commissions (and it typically will be), returns are automatically higher. Should dealing with the ETF directly not be desirable and a broker must be used, much research and consideration should be put into the decision, period. Online investment website Morningstar.com breaks it down like so. Using the S&P 500 index as basis, Morningstar experts calculate that a $10,000 investment requires an average of two years to see return on investment; this suggests the following two keys to profit in ETF investment.

Number two on the list of rules essential to success is the investment amount. Ten thousand dollars, as shown above, is a decent start for the ETF investment. Note the use of “the” in the preceding sentence: A single investment is strongly recommended as well for, again, commissions will kill or seriously forestall returns on investment.

Last but not least is the easiest of all: Leave it alone. ETF trading is intraday, which in itself implies that trading activity is slow and very deliberate. Indeed, the creation of the ETF certainly had long-term investment in mind.

However, the disadvantage of ETF investment can prove to be exactly the opposite to the right kind of investor. Those that prefer a laissez-faire attitude to investment should find ETFs one of the most attractive opportunities out there. ETFs are perfect for those wanting to, as an old infomercial used to say, “set it and forget it.”

Most exchange trust funds carry one of three legal structures. Open-end index fund refers to a fund structure registered under the SEC Investment Company Act of 1940 which reinvests dividends. Dividends are paid quarterly, and derivative and loan securities are permissible for use in the open-end index fund.

The unit investment trust is also registered under the SEC Investment Company Act of 1940 and pays dividends quarterly; dividends are not reinvested in a unit investment trust, however.

The grantor trust is a fund structure that pays dividends directly; it also offers investors an advantage in its voting rights within the fund’s securities. The grantor trust is not registered under the SEC Investment Company Act of 1940 and is mostly known for its use in the Merrill Lynch HOLDRs.

The most widely held ETF today is the Standard & Poor’s Depository Receipt, a format with origins in the very first ETF ever traded in the United States. Other ETFs are tied in with the Dow Jones Industrial Average or the Nasdaq 100 index; these are known as “diamonds” and “qubes,” respectively. Diamonds, qubes and SPDRs are unit investment trusts.

Open-end index funds known as “iShares” are exchange-traded securities composed of more than sixty index funds. The funds are compiled by an index provider from among Cohen & Steers Capital Management, Inc.; Dow Jones & Company; the Frank Russell Company; Goldman, Sachs & Company; Morgan Stanley Capital International, Inc.; the Nasdaq stock market; and Standard & Poor’s. The iShares schemes listed below are distributed by broker / dealer SEI Investments Distribution Co. with Barclays Global Fund Advisors serving in advisory capacity.

In terms of assets at the conclusion of year 2005, the list of top-ranked American ETFs includes the following.

The DIAMONDS Trust (Series 1) is unit investment trust in Dow Jones Industrial Average equity securities and thus reflect that index provider’s price and yield. DIAMONDS is distributed by broker / dealer ALPS Distributors, Inc.
iShares are extremely popular, as evidenced by their prominence in this list. the iShares Dow Jones Select Dividend Index Fund is the most successful of all; this one is tied in with the Dow Jones Select Dividend Index, a group of one hundred high yield securities. The Dow Jones Select Dividend Index is in turn a broad index of the total U.S. equity security market.
Blessed with easy to understand names, the iShares MSCI EAFE Index Fund, the iShares MSCI Emerging Markets Index Fund, the iShares MSCI Japan Index Fund, the iShares Russell 2000 Index Fund and the iShares Standard & Poor’s 500 Index Fund are all named for the index on which investment rules are based.

MidCap spiders (or Standard & Poor Depository Receipts) investment returns are based on the performance of the S&P Midcap 400 Composite Price Index and in actuality represent co-ownership in the MidCap SPDR Trust (Series 1). Sector SPDRs, despite their status as unit investment trusts, are open-end funds concerned with separate industry groups within the S&P 500. The most heavily traded ETF, Qubes are tied in with the Nasdaq 100 index and are thus heavily dependent on the technology industry.

State Street Global Advisors manages an ETF group known as streetTRACKS. streetTRACKS is based on a multitude of indices from the Dow Jones global market to Morgan Stanley Dean Witter’s technology indices.

Part three. A vehicle for the future of investment

As they like to say in the business, “Past performance is no guarantee of future results.” In year 2006, however, it’s hard not to be giddy over the opportunities seemingly so prevalent on the ETF market. The longer-winded caveat appearing on investment websites, advertisements and publicity material – “Exchange traded funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost” – is good sober wisdom to keep in mind, but ETFs will probably continue to be worth the low risk associated with them in the near future. After all, ETFs have been perhaps the single hottest trends in the stock market for three years running and, with the recent popularity of commodity-based ETFs, show no sign of slowing.

Indeed, the ETF market is still moving at such blinding speeds with such unforeseen schemes offered literally almost daily (one Global Trends Investment executive said in response to Tiburon Strategic Advisors analysis undertaken in 2005 and 2006 that “the ETF marketplace continues to expand at an exponential rate.”), today’s innovations will most likely become taken for granted and old hat tomorrow. Commodity ETFs and currency ETFs, to cite just two examples, were unthinkable three years ago and now are inspiring competitors in different markets. The fact that some thirty funds are now trading at a volume of 1,000,000 shares daily (and ETFs are generally considered low-volume traders) for three months now has become commonplace already, with ETF enthusiasts imagining the 2,000,000 barrier broken.

Nevertheless, perhaps we can ignore the traditional admonishments about past results, if only to attempt to glean a little knowledge from the trends of today (or of this writing).

March 2006 saw the release of an extensive 300-page study regarding ETFs released by market research and consulting giant Tiburon Strategic Advisors. At $5,000 per copy, this writer hardly has the funds to spend on such a thing, but most sources are not afraid to say that oil investment looks good, and that the future looks much brighter for small investors in ETFs.

What can be surmised from today’s market buzz? Firstly, a myriad of advisors are sounding the all-clear on past alarms from those unsure about ETF investment toward retirement. Again, the problem with small investment in ETFs is – surely you remember – broker commissions. Over the past year and a half, though, many have found a solution in a handful of software programs designed to deal with this particular problem and released within the last twelve months. Such software has assisted in further investor confidence in making ETFs a part of retirement 401(k) plans and opens the market to investors of all sizes and investment interests.

The hype of 2006 is clearly tightly focused on commodities and a mushrooming of the ETF commodity market. Gold, the first resource commodified for ETF, has inspired the proposal and/or release of products such as copper, zinc, oil and silver. The former two have reached all-time highs this year and silver – clearly the most popular choice for new launches in 2006 – prices have hit a 23-year high; Barclays’ iShares Silver Trust is about to join their long and successful list of iShare ETFs. Ameristock Funds and Macro Securities Depositor LLC are planning oil commodity ETF launches, with Macro Securities actually releasing two simultaneously.

Led by commodity funds managed by Deutsche Bank, Dow Jones-AIG, and Goldman Sachs, the commodity ETF market has already seen $80 billion in assets; add this to the very real possibility that commodity funds will multiply in number by hundreds of percent in this year alone, the future for commodity funds appears clear and prosperous, although fears that this bubble must burst soon are extant. And this market needn’t stop at metals, either: The Petroleum Fund of Norway and California-based retirement fund powerhouse Calpers have moved into the farm goods sphere.

As the Euro becomes more widespread, attention will continue to be drawn to investments in the currency. Rydex Investments, a firm priding itself on the role of “a creative inventor of alternative mutual funds” is planning the Rydex Euro Currency Trust, an ETF based on the value of the Euro and the first currency-based ETF of any sort. Though seemingly unlikely to inspire the creation of ETFs tied in with any other currency (though the Japanese yen might yet make a nice foundation), future investment strategies based on Euro movement are certain to pop up.

In response to the expansion of the European Union through accession, Austria and Austrian banks have become a trendy investment target as of late. As Central and Eastern European economies flourish with their burgeoning middle class, the desire for diversification for publicly traded company investment is increasing just about as quickly. The new iShares Austria fund is designed to take advantage of the influence Austrian banks exert over the region. Despite the boom going on in Central and European countries, salaries lag behind for the nonce. Economic growth spurred on from without will continue in the short term in Central and Eastern Europe, thanks to inexpensive manufacturing costs, cheaper labor (Slovakia, poorest of the new member states, offers salaries ten percent that of Germany’s) and lots of construction projects. While the wave of progress continues to wash over the region, Austrian-based ETF is a decent idea. Again: This is most likely a short-term phenomenon.

With the 21st century comes 21st century technology. Eyes will be turning to the Nasdaq more and more frequently as the years progress, and currently the ETF market in this sphere features funds specific to certain technological branches.

The biotechnology industry seems certain to boom in the near future, regardless of the amount of stem cell research allowed in the United States. The exchange traded fund known as the iShares Nasdaq Biotechnology ETF is composed purely of companies involved in pharmaceutical research and development with biological material. In general, the biotechnology sector has been taking losses for some time, but these losses are on a steady decrease. This ETF is rather undiversified at present; Amgen makes up a whopping one-sixth of the ETF’s holdings, and most companies within the ETF are small sized and even startups. On the plus side, few other sectors can pay out slot machine jackpot fashion as can biotechnology. Biotech companies are made household names with a single drug brought to market. Once these firms have dug the industry out of its hole – federal-level policy changes and encouragement regarding stem cell research and gene therapy – the sky is surely the limit on these.

Alternative energy is a catchphrase for our decade as well. Nations such as Germany, Holland and the Scandinavian four have seen alternative energy sources carve a noticeable (if sometimes small) niche in their investment markets. Naturally, ETFs would follow; combined with the current state of skyrocketing fuel prices, growing government subsidies and even Bill Gates’ financial attention, green energy sources are a definite fruitful source of investment in the future. Most noteworthy for 2006 is the PowerShares WilderHill Clean Energy ETF. Including fuel-cell makers Plug Power, Inc. and Capstone Turbine Corporation in the fund, the PowerShares ETF has had an asset increase from $190 million to $400 million, a 210 percent increase, in just a bit more than the first quarter of the year and trading of the ETF has doubled in the past six months.

One upstart firm all the rage in the industry in 2006 might also provide a clue to the future through an examination of their diversification choices.

The Coolcat ETF & Fidelity Select Report has, by at least one account, “taken the ETF world by storm.” While its performance over the previous twelve months has been exemplary, Coolcat deserves (and gets) high praise for its innovative and aggressive strategies. At an almost forty percent return for the period of April 2005 to March 2006, the Coolcat ETF Portfolio outperformed its closest competitor by over twelve percent. Coolcat has been singled out because the overwhelming majority of investment newsletters making the jump to ETF portfolio establishment have been pursuing the breakeven point since inception.

The Coolcat ETF Portfolio is distinctive in its amazing range of investment opportunities: International ETFs such as the iShares Brazil Index Fund (a key factor in the Coolcat success story), the iShares Mexico Index Fund, the South Africa Index Fund and the iShares Emerging Markets Index Fund provide some nice opportunities for steady growth (and even ballooning growth in the case of the Brazil fund, which nearly doubled in value in fifteen months) in the portfolio.

Alongside these international interests in the portfolio sit the S&P 500 Energy Sector (up eighty-six percent since Coolcat acquisition of shares), iShares Dow Jones Transportation Average IYT, PowerShares Dynamic Semiconductors and alternative energy fund PowerShares WilderHill Clean Energy fund (see above). Further, Coolcat boasts interests in the gold commodity ETF market.

Coolcat’s success implies that stock market-like playing is possible and advantageous in the ETF market; their heavy emphasis on foreign ETFs is surely temporary, for it is grounded in figures that say ten of the top sixteen ETFs over the past six months have been foreign-based. Common wisdom has it that such aggressiveness should probably be tempered, however, by smaller investors in anything beyond the short term.

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